SECURITIES AND EXCHANGE COMMISSION
FORM 10-Q
(Mark One)
| x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 | |
| For the quarterly period ended | ||
OR
| o | ||
| For the transition period fromto |
Commission file number 1-6089
H&R BLOCK, INC.
| MISSOURI (State or other jurisdiction of incorporation or organization) | 44-0607856 (I.R.S. Employer Identification No.) |
4400 Main Street
Kansas City, Missouri 64111
(Address of principal executive offices, including zip code)
(816) 753-6900
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes [X]x No [ ]o
The number of shares outstanding of the registrant’s Common Stock, without par value, at the close of business on FebruaryNovember 28, 2003 was 179,111,604178,278,294 shares.
TABLE OF CONTENTS
| Page | |||||
| PART I Financial Information | |||||
| Condensed Consolidated Balance Sheets | 1 | ||||
| Condensed Consolidated Income Statements Three and | 2 | ||||
| Condensed Consolidated Statements of Cash Flows | 3 | ||||
| Notes to Condensed Consolidated Financial Statements | 4 | ||||
| Management’s Discussion and Analysis of Results of Operations and Financial Condition | |||||
| Quantitative and Qualitative Disclosures about Market Risk | |||||
| Controls and Procedures | |||||
| PART II Other Information | |||||
| SIGNATURES | |||||
H&R BLOCK, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
Amounts in thousands, except share amounts
| October 31, | April 30, | |||||||||||
| 2003 | 2003 | |||||||||||
| (Unaudited) | ||||||||||||
ASSETS | ||||||||||||
| Cash and cash equivalents | $ | 261,330 | $ | 875,353 | ||||||||
| Cash and cash equivalents — restricted | 571,163 | 438,242 | ||||||||||
| Receivables from customers, brokers, dealers and clearing organizations, net | 584,721 | 517,037 | ||||||||||
| Receivables, net (note 4) | 340,794 | 403,197 | ||||||||||
| Prepaid expenses and other current assets | 638,496 | 513,532 | ||||||||||
| Total current assets | 2,396,504 | 2,747,361 | ||||||||||
| Residual interests in securitizations (note 5) | 317,604 | 264,337 | ||||||||||
| Mortgage servicing rights (note 5) | 111,960 | 99,265 | ||||||||||
| Property and equipment, at cost less accumulated depreciation and amortization of $523,897 and $485,608 | 283,556 | 288,594 | ||||||||||
| Intangible assets, net (note 6) | 350,188 | 341,865 | ||||||||||
| Goodwill, net (note 6) | 830,053 | 714,215 | ||||||||||
| Other assets | 171,511 | 148,268 | ||||||||||
| Total assets | $ | 4,461,376 | $ | 4,603,905 | ||||||||
LIABILITIES AND STOCKHOLDERS’ EQUITY | ||||||||||||
Liabilities: | ||||||||||||
| Current portion of long-term debt | $ | 25,385 | $ | 55,678 | ||||||||
| Notes payable — commercial paper | 124,630 | — | ||||||||||
| Accounts payable to customers, brokers and dealers | 999,009 | 862,694 | ||||||||||
| Accounts payable, accrued expenses and other | 455,362 | 468,933 | ||||||||||
| Accrued salaries, wages and payroll taxes | 83,202 | 210,629 | ||||||||||
| Accrued income taxes | 130,614 | 299,262 | ||||||||||
| Total current liabilities | 1,818,202 | 1,897,196 | ||||||||||
| Long-term debt | 807,738 | 822,302 | ||||||||||
| Other noncurrent liabilities | 299,539 | 220,698 | ||||||||||
| Total liabilities | 2,925,479 | 2,940,196 | ||||||||||
Stockholders’ equity: | ||||||||||||
| Common stock, no par, stated value $.01 per share | 2,179 | 2,179 | ||||||||||
| Additional paid-in capital | 510,951 | 496,393 | ||||||||||
| Accumulated other comprehensive income (note 8) | 62,628 | 36,862 | ||||||||||
| Retained earnings | 2,169,317 | 2,221,868 | ||||||||||
| Less cost of 40,343,784 and 38,343,944 shares of common stock in treasury | (1,209,178 | ) | (1,093,593 | ) | ||||||||
| Total stockholders’ equity | 1,535,897 | 1,663,709 | ||||||||||
| Total liabilities and stockholders’ equity | $ | 4,461,376 | $ | 4,603,905 | ||||||||
See Notes to Condensed Consolidated Financial Statements
-1-
H&R BLOCK, INC.
CONDENSED CONSOLIDATED BALANCE SHEETSAmounts in thousands, except share amounts
| January 31, | April 30, | |||||||||
| 2003 | 2002 | |||||||||
| ASSETS | (Unaudited) | (Audited) | ||||||||
CURRENT ASSETS | ||||||||||
| Cash and cash equivalents | $ | 436,918 | $ | 436,145 | ||||||
| Cash and cash equivalents — restricted | 418,721 | 152,173 | ||||||||
| Marketable securities — trading | 18,365 | 28,370 | ||||||||
| Receivables from customers, brokers, dealers and clearing organizations, less allowance of $1,741 and $1,785 | 546,251 | 844,538 | ||||||||
| Receivables, less allowance of $25,762 and $64,057 | 465,195 | 368,345 | ||||||||
| Prepaid expenses and other current assets | 476,785 | 415,572 | ||||||||
| TOTAL CURRENT ASSETS | 2,362,235 | 2,245,143 | ||||||||
INVESTMENTS AND OTHER ASSETS | ||||||||||
| Investments in available-for-sale marketable securities | 16,464 | 15,260 | ||||||||
| Residual interests in securitizations | 274,353 | 365,371 | ||||||||
| Intangible assets, net | 351,766 | 383,085 | ||||||||
| Goodwill, net | 724,759 | 723,856 | ||||||||
| Property and equipment, at cost less accumulated depreciation and amortization of $462,393 and $410,885 | 294,222 | 286,500 | ||||||||
| Other | 225,437 | 211,576 | ||||||||
| $ | 4,249,236 | $ | 4,230,791 | |||||||
LIABILITIES AND STOCKHOLDERS’ EQUITY | ||||||||||
CURRENT LIABILITIES | ||||||||||
| Notes payable | $ | 586,803 | $ | — | ||||||
| Accounts payable to customers, brokers and dealers | 823,890 | 903,201 | ||||||||
| Accounts payable, accrued expenses and deposits | 439,016 | 410,622 | ||||||||
| Accrued salaries, wages and payroll taxes | 179,545 | 253,401 | ||||||||
| Accrued income taxes | 70,117 | 252,822 | ||||||||
| Current portion of long-term debt | 53,369 | 59,656 | ||||||||
| TOTAL CURRENT LIABILITIES | 2,152,740 | 1,879,702 | ||||||||
LONG-TERM DEBT | 828,900 | 868,387 | ||||||||
OTHER NONCURRENT LIABILITIES | 100,106 | 113,282 | ||||||||
STOCKHOLDERS’ EQUITY | ||||||||||
| Common stock, no par, stated value $.01 per share | 2,179 | 2,179 | ||||||||
| Additional paid-in capital | 498,315 | 468,052 | ||||||||
| Accumulated other comprehensive income | 22,718 | 44,128 | ||||||||
| Retained earnings | 1,759,479 | 1,767,702 | ||||||||
| Less cost of 39,079,131 and 36,819,739 shares of common stock in treasury | (1,115,201 | ) | (912,641 | ) | ||||||
| TOTAL STOCKHOLDERS’ EQUITY | 1,167,490 | 1,369,420 | ||||||||
| $ | 4,249,236 | $ | 4,230,791 | |||||||
See Notes to Consolidated Financial Statements
-1-
H&R BLOCK, INC.CONSOLIDATEDINCOME STATEMENTS OF OPERATIONS
Unaudited, amounts in thousands, except per share amounts
| Three Months Ended | Nine Months Ended | |||||||||||||||||
| January 31, | January 31, | |||||||||||||||||
| 2003 | 2002 | 2003 | 2002 | |||||||||||||||
Revenues | ||||||||||||||||||
| Service revenues | $ | 510,042 | $ | 484,857 | $ | 907,015 | $ | 838,324 | ||||||||||
| Gain on sale of mortgage assets: | ||||||||||||||||||
| Mortgage loans and related assets | 175,483 | 107,882 | 471,868 | 322,302 | ||||||||||||||
| Residual interests previously securitized | 130,881 | — | 130,881 | — | ||||||||||||||
| Interest income | 57,230 | 54,030 | 228,176 | 148,122 | ||||||||||||||
| Product sales | 43,312 | 41,967 | 74,234 | 63,718 | ||||||||||||||
| Royalties | 39,026 | 33,329 | 43,082 | 37,772 | ||||||||||||||
| Other | 2,439 | 11,467 | 5,919 | 26,171 | ||||||||||||||
| 958,413 | 733,532 | 1,861,175 | 1,436,409 | |||||||||||||||
Operating expenses | ||||||||||||||||||
| Employee compensation and benefits | 352,209 | 321,353 | 791,692 | 698,069 | ||||||||||||||
| Occupancy and equipment | 87,349 | 72,678 | 223,642 | 194,106 | ||||||||||||||
| Operating interest | 2,585 | 3,904 | 9,739 | 19,972 | ||||||||||||||
| Other interest | 22,232 | 26,829 | 60,050 | 70,351 | ||||||||||||||
| Depreciation and amortization | 42,670 | 38,167 | 114,738 | 107,095 | ||||||||||||||
| Marketing and advertising | 55,331 | 51,905 | 85,335 | 74,966 | ||||||||||||||
| Supplies, freight and postage | 33,154 | 22,008 | 55,472 | 38,051 | ||||||||||||||
| Bad debt provision | 25,457 | 33,095 | 40,472 | 50,194 | ||||||||||||||
| Texas litigation reserve | — | — | 41,672 | — | ||||||||||||||
| Impairment of goodwill | — | — | 24,000 | — | ||||||||||||||
| Other | 117,134 | 114,647 | 274,156 | 235,839 | ||||||||||||||
| 738,121 | 684,586 | 1,720,968 | 1,488,643 | |||||||||||||||
| Operating earnings (loss) | 220,292 | 48,946 | 140,207 | (52,234 | ) | |||||||||||||
| Other income, net | 2,642 | 828 | 4,576 | 3,193 | ||||||||||||||
| Earnings (loss) before income taxes | 222,934 | 49,774 | 144,783 | (49,041 | ) | |||||||||||||
| Income tax (benefit) | 90,621 | 20,158 | 59,361 | (19,862 | ) | |||||||||||||
| Net earnings (loss) | $ | 132,313 | $ | 29,616 | $ | 85,422 | $ | (29,179 | ) | |||||||||
| Basic earnings (loss) per share | $ | .74 | $ | .16 | $ | .48 | $ | (.16 | ) | |||||||||
| Diluted earnings (loss) per share | $ | .73 | $ | .16 | $ | .46 | $ | (.16 | ) | |||||||||
| Dividends per share | $ | .18 | $ | .16 | $ | .51 | $ | .47 | ||||||||||
| Three Months Ended | Six Months Ended | ||||||||||||||||
| October 31, | October 31, | ||||||||||||||||
| 2003 | 2002 | 2003 | 2002 | ||||||||||||||
Revenues: | |||||||||||||||||
| Service revenues | $ | 236,800 | $ | 206,404 | $ | 446,262 | $ | 396,973 | |||||||||
| Gains on sales of mortgage assets | 220,289 | 151,377 | 412,928 | 296,385 | |||||||||||||
| Interest income | 87,868 | 92,726 | 158,819 | 170,946 | |||||||||||||
| Product sales | 28,164 | 15,510 | 56,515 | 30,922 | |||||||||||||
| Royalties | 3,416 | 2,855 | 4,983 | 4,056 | |||||||||||||
| Other | 3,318 | 2,524 | 6,038 | 3,480 | |||||||||||||
| 579,855 | 471,396 | 1,085,545 | 902,762 | ||||||||||||||
Operating expenses: | |||||||||||||||||
| Employee compensation and benefits | 255,764 | 229,295 | 480,969 | 439,483 | |||||||||||||
| Occupancy and equipment | 82,314 | 71,431 | 158,465 | 136,293 | |||||||||||||
| Interest | 19,900 | 22,698 | 43,096 | 44,972 | |||||||||||||
| Depreciation and amortization | 40,080 | 36,495 | 76,010 | 72,068 | |||||||||||||
| Marketing and advertising | 21,683 | 20,818 | 31,791 | 30,004 | |||||||||||||
| Supplies, freight and postage | 14,187 | 13,852 | 22,741 | 22,318 | |||||||||||||
| Impairment of goodwill | — | 6,000 | — | 24,000 | |||||||||||||
| Other | 129,957 | 133,495 | 239,369 | 213,709 | |||||||||||||
| 563,885 | 534,084 | 1,052,441 | 982,847 | ||||||||||||||
| Operating income (loss) | 15,970 | (62,688 | ) | 33,104 | (80,085 | ) | |||||||||||
| Other income, net | 1,164 | 443 | 2,859 | 1,934 | |||||||||||||
| Income (loss) before taxes | 17,134 | (62,245 | ) | 35,963 | (78,151 | ) | |||||||||||
| Income taxes (benefit) | 6,758 | (24,898 | ) | 14,068 | (31,260 | ) | |||||||||||
| Net income (loss) before cumulative effect of change in accounting principle | 10,376 | (37,347 | ) | 21,895 | (46,891 | ) | |||||||||||
| Cumulative effect of change in accounting principle for multiple deliverable revenue arrangements, less taxes of $4,031 | — | — | (6,359 | ) | — | ||||||||||||
| Net income (loss) | $ | 10,376 | $ | (37,347 | ) | $ | 15,536 | $ | (46,891 | ) | |||||||
Basic earnings (loss) per share: | |||||||||||||||||
| Before change in acctg. principle | $ | .06 | $ | (.21 | ) | $ | .12 | $ | (.26 | ) | |||||||
| Cumulative effect of change in accounting principle | — | — | (.03 | ) | — | ||||||||||||
| Net income (loss) | $ | .06 | $ | (.21 | ) | $ | .09 | $ | (.26 | ) | |||||||
Diluted earnings (loss) per share: | |||||||||||||||||
| Before change in acctg. principle | $ | .06 | $ | (.21 | ) | $ | .12 | $ | (.26 | ) | |||||||
| Cumulative effect of change in accounting principle | — | — | (.03 | ) | — | ||||||||||||
| Net income (loss) | $ | .06 | $ | (.21 | ) | $ | .09 | $ | (.26 | ) | |||||||
See Notes to Condensed Consolidated Financial StatementsStatments
-2-
H&R BLOCK, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
Unaudited, amounts in thousands
| Nine Months Ended | ||||||||||
| January 31, | ||||||||||
| 2003 | 2002 | |||||||||
Cash flows from operating activities: | ||||||||||
| Net earnings (loss) | $ | 85,422 | $ | (29,179 | ) | |||||
| Adjustments to reconcile net earnings (loss) to net cash used in operating activities: | ||||||||||
| Depreciation and amortization | 114,738 | 107,095 | ||||||||
| Provision for bad debt | 40,472 | 50,194 | ||||||||
| Accretion of acquisition liabilities | 7,079 | 8,999 | ||||||||
| Tax benefit from stock option exercises | 31,168 | 55,004 | ||||||||
| Accretion of residual interests in securitizations | (113,146 | ) | (29,297 | ) | ||||||
| Adjustments to fair value of residual interests in securitizations | 25,589 | 29,642 | ||||||||
| Realized gain on sale of residual interests previously securitized | (130,881 | ) | — | |||||||
| Additions to trading securities — residual interests in securitizations | (326,395 | ) | (426,409 | ) | ||||||
| Proceeds from net interest margin transactions | 325,642 | 412,715 | ||||||||
| Impairment of goodwill | 24,000 | — | ||||||||
| Changes in working capital, net | (450,437 | ) | (1,099,612 | ) | ||||||
Net cash used in operating activities | (366,749 | ) | (920,848 | ) | ||||||
Cash flows from investing activities: | ||||||||||
| Available-for-sale securities: | ||||||||||
| Purchases of available-for-sale securities | (10,577 | ) | (3,695 | ) | ||||||
| Cash received from residual interests in securitizations | 117,522 | 33,006 | ||||||||
| Cash proceeds from sale of residual interests previously securitized | 142,486 | — | ||||||||
| Maturities of other available-for-sale securities | 9,730 | 28,203 | ||||||||
| Purchases of property and equipment, net | (95,629 | ) | (71,343 | ) | ||||||
| Payments made for business acquisitions, net of cash acquired | (24,239 | ) | (44,397 | ) | ||||||
| Other, net | (6,004 | ) | (8,538 | ) | ||||||
Net cash provided by (used in) investing activities | 133,289 | (66,764 | ) | |||||||
Cash flows from financing activities: | ||||||||||
| Repayments of notes payable | (9,301,285 | ) | (6,147,398 | ) | ||||||
| Proceeds from issuance of notes payable | 9,888,088 | 7,786,230 | ||||||||
| Payments on acquisition debt | (52,107 | ) | (49,479 | ) | ||||||
| Dividends paid | (93,645 | ) | (86,349 | ) | ||||||
| Payments to acquire treasury shares | (317,608 | ) | (352,213 | ) | ||||||
| Proceeds from issuance of common stock | 112,813 | 186,825 | ||||||||
| Other, net | (2,023 | ) | 688 | |||||||
Net cash provided by financing activities | 234,233 | 1,338,304 | ||||||||
Net increase in cash and cash equivalents | 773 | 350,692 | ||||||||
Cash and cash equivalents at beginning of the period | 436,145 | 187,616 | ||||||||
Cash and cash equivalents at end of the period | $ | 436,918 | $ | 538,308 | ||||||
Supplemental cash flow disclosures: | ||||||||||
| Income taxes paid | $ | 176,168 | $ | 162,902 | ||||||
| Interest paid | 55,193 | 72,896 | ||||||||
| Six Months Ended | ||||||||||||
| October 31, | ||||||||||||
| 2003 | 2002 | |||||||||||
Cash flows from operating activities: | ||||||||||||
| Net income (loss) | $ | 15,536 | $ | (46,891 | ) | |||||||
| Adjustments to reconcile net income (loss) to net cash used in operating activities: | ||||||||||||
| Depreciation and amortization | 76,010 | 72,068 | ||||||||||
| Accretion of residual interests in securitizations | (70,906 | ) | (92,853 | ) | ||||||||
| Impairments of residual interests in securitizations | 11,106 | 24,132 | ||||||||||
| Additions to trading securities — residual interests in securitizations | (199,021 | ) | (136,766 | ) | ||||||||
| Proceeds from net interest margin transactions, net | 147,107 | 136,013 | ||||||||||
| Additions to mortgage servicing rights | (48,002 | ) | (37,968 | ) | ||||||||
| Amortization of mortgage servicing rights | 35,307 | 20,087 | ||||||||||
| Net change in receivable from Trusts | (54,483 | ) | (19,828 | ) | ||||||||
| Cumulative effect of change in accounting principle | 6,359 | — | ||||||||||
| Impairment of goodwill | — | 24,000 | ||||||||||
| Mortgage loans held for sale: | ||||||||||||
| Originations and purchases | (11,650,851 | ) | (7,930,567 | ) | ||||||||
| Sales and principal repayments | 11,634,472 | 7,848,969 | ||||||||||
| Other net changes in working capital, net of acquisitions | (365,984 | ) | (210,224 | ) | ||||||||
Net cash used in operating activities | (463,350 | ) | (349,828 | ) | ||||||||
Cash flows from investing activities: | ||||||||||||
| Available-for-sale securities: | ||||||||||||
| Purchases of available-for-sale securities | (9,557 | ) | (7,692 | ) | ||||||||
| Cash received from residual interests in securitizations | 68,850 | 103,885 | ||||||||||
| Sales of other available-for-sale securities | 13,721 | 7,946 | ||||||||||
| Purchases of property and equipment, net | (43,591 | ) | (57,003 | ) | ||||||||
| Payments made for business acquisitions, net of cash acquired | (123,337 | ) | (21,397 | ) | ||||||||
| Other, net | 2,527 | (2,813 | ) | |||||||||
Net cash provided by (used in) investing activities | (91,387 | ) | 22,926 | |||||||||
Cash flows from financing activities: | ||||||||||||
| Repayments of notes payable | (499,771 | ) | (6,430,067 | ) | ||||||||
| Proceeds from issuance of notes payable | 624,401 | 6,911,680 | ||||||||||
| Proceeds from securitization financing | 50,100 | — | ||||||||||
| Payments on acquisition debt | (45,100 | ) | (47,995 | ) | ||||||||
| Dividends paid | (68,087 | ) | (61,474 | ) | ||||||||
| Acquisition of treasury shares | (178,847 | ) | (313,603 | ) | ||||||||
| Proceeds from issuance of common stock | 59,851 | 94,667 | ||||||||||
| Other, net | (1,833 | ) | (1,536 | ) | ||||||||
Net cash provided by (used in) financing activities | (59,286 | ) | 151,672 | |||||||||
Net decrease in cash and cash equivalents | (614,023 | ) | (175,230 | ) | ||||||||
Cash and cash equivalents at beginning of the period | 875,353 | 436,145 | ||||||||||
Cash and cash equivalents at end of the period | $ | 261,330 | $ | 260,915 | ||||||||
See Notes to Condensed Consolidated Financial Statements
-3-
| 1. | Basis of Presentation |
The condensed consolidated balance sheet as of October 31, 2003, the condensed consolidated income statements for the three and six months ended October 31, 2003 and 2002, and the condensed consolidated statements of cash flows for the six months ended October 31, 2003 and 2002 have been prepared by the Company, without audit. In the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position, results of operations and cash flows at October 31, 2003 and for all periods presented have been made.
Financial results for the three months ended July 31, 2003 have been restated as a result of the adoption of Emerging Issues Task Force Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” (EITF 00-21). See note 13 to the condensed consolidated financial statements for additional information.
Certain reclassifications have been made to prior year amounts to conform to the current year presentation. These reclassifications had no effect on the results of operations or stockholders’ equity as previously reported.
Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted. These condensed consolidated financial statements should be read in conjunction with the financial statements and notes thereto included in the Company’s April 30, 2003 Annual Report to Shareholders on Form 10-K.
Operating revenues of the U.S. Tax Operations, Business Services and International Tax Operations segments are seasonal in nature with peak revenues occurring in the months of January through April. Therefore, results for interim periods are not indicative of results to be expected for the full year.
The Company files its Federal and state income tax returns on a calendar year basis. The condensed consolidated income statements reflect the effective tax rates expected to be applicable for the respective full fiscal years.
| 2. | ||
During the six months ended October 31, 2003, cash payments of $118,828 were made or accrued related to the acquisition of assets in the franchise territories of ten former major franchisees. See discussion related to litigation involving major franchisees in note 11 to the condensed consolidated financial statements.
Results related to the ten former major franchise territories, from the dates company-owned operations commenced, have been included in the accompanying condensed consolidated financial statements.
-4-
Due to pending litigation, the purchase price allocations have not been finalized. The preliminary allocation of the purchase price to assets acquired is as follows: property and equipment of $4,168; goodwill of $83,267; customer relationships of $21,362 and noncompete agreements of $10,031. The customer relationships and noncompete agreements will be amortized over ten years and three years, respectively, and the weighted average life of the intangible assets is approximately eight years. Goodwill recognized in these transactions is included in the U.S. Tax Operations segment and all but $3,304 is deductible for tax purposes. The preliminary purchase price allocations will be adjusted upon determination of the final purchase price.
| Earnings (Loss) Per Share |
| Three months ended | Nine months ended | ||||||||||||||||
| January 31, | January 31, | ||||||||||||||||
| 2003 | 2002 | 2003 | 2002 | ||||||||||||||
| (dollars and shares in thousands) | |||||||||||||||||
| Net earnings (loss) | $ | 132,313 | $ | 29,616 | $ | 85,422 | $ | (29,179 | ) | ||||||||
| Basic weighted average shares | 178,770 | 182,936 | 179,620 | 183,028 | |||||||||||||
| Effect of dilutive securities: | |||||||||||||||||
| Common stock options | 3,402 | 5,244 | 4,757 | — | |||||||||||||
| Convertible preferred stock | 1 | 1 | 1 | — | |||||||||||||
| Dilutive potential shares | 182,173 | 188,181 | 184,378 | 183,028 | |||||||||||||
| Net earnings (loss) per share: | |||||||||||||||||
| Basic | $ | .74 | $ | .16 | $ | .48 | $ | (.16 | ) | ||||||||
| Diluted | $ | .73 | $ | .16 | $ | .46 | $ | (.16 | ) | ||||||||
-4-Basic earnings (loss) per share is computed using the weighted average shares outstanding during each period. The dilutive effect of potential common shares is included in diluted earnings per share. The computations of basic and diluted earnings (loss) per share are as follows:
| (in 000s, except per share amounts) | Three months ended | Six months ended | |||||||||||||||
| October 31, | October 31, | ||||||||||||||||
| 2003 | 2002 | 2003 | 2002 | ||||||||||||||
| Net income (loss) before change in accounting principle | $ | 10,376 | $ | (37,347 | ) | $ | 21,895 | $ | (46,891 | ) | |||||||
| Basic weighted average common shares | 177,828 | 178,880 | 178,616 | 180,045 | |||||||||||||
| Dilutive potential shares from stock options and restricted stock | 3,282 | — | 3,348 | — | |||||||||||||
| Convertible preferred stock | 1 | — | 1 | — | |||||||||||||
| Dilutive weighted average common shares | 181,111 | 178,880 | 181,965 | 180,045 | |||||||||||||
| Earnings (loss) per share before change in accounting principle: | |||||||||||||||||
| Basic and diluted | $ | .06 | $ | (.21 | ) | $ | .12 | $ | (.26 | ) | |||||||
Diluted earnings per share excludes the impact of shares of common stock issuable upon the exercise of options to purchase 6.5 million shares of stock as of October 31, 2003, as the options’ exercise prices were greater than the average market price of the common shares and therefore, the effect would be antidilutive. Diluted loss per share as of October 31, 2002 excludes the impact of 19.0 million shares issuable upon the exercise of stock options and the conversion of 1,216 shares of preferred stock to common stock, as they are antidilutive.
The weighted average shares outstanding for the three and six months ended October 31, 2003 decreased to 177.8 million and 178.6 million, respectively, from 178.9 million and 180.0 million last year, respectively, primarily due to the purchase of treasury shares by the Company. The effect of these purchases was partially offset by the issuance of treasury shares related to the Company’s stock-based compensation plans.
-5-
| Three months ended | Nine months ended | |||||||||||||||
| January 31, | January 31, | |||||||||||||||
| 2003 | 2002 | 2003 | 2002 | |||||||||||||
| Net earnings (loss) | $ | 132,313 | $ | 29,616 | $ | 85,422 | $ | (29,179 | ) | |||||||
| Change in net unrealized gain or loss on marketable securities | (65,585 | ) | (3,729 | ) | (31,385 | ) | 21,877 | |||||||||
| Change in foreign currency translation adjustments | 9,204 | (565 | ) | 9,975 | (4,294 | ) | ||||||||||
| Comprehensive income (loss) | $ | 75,932 | $ | 25,322 | $ | 64,012 | $ | (11,596 | ) | |||||||
During the six months ended October 31, 2003, the Company acquired 4.2 million shares of its common stock at an aggregate cost of $178,847. During the six months ended October 31, 2002, the Company acquired 6.5 million shares of its common stock at an aggregate cost of $313,603.
| 4. | ||
| January 31, | April 30, | |||||||
| 2003 | 2002 | |||||||
| (Unaudited) | (Audited) | |||||||
| Business Services accounts receivable | $ | 171,116 | $ | 177,321 | ||||
| Mortgage loans held for sale | 85,122 | 71,855 | ||||||
| Tax related fees due from Household Bank | 60,187 | 2,300 | ||||||
| Loans to franchisees | 44,961 | 31,055 | ||||||
| Royalties from franchisees | 34,211 | 134 | ||||||
| Participation in refund anticipation loans | 3,229 | 33,530 | ||||||
| Software receivables | 21,667 | 34,679 | ||||||
| Other | 70,464 | 81,528 | ||||||
| 490,957 | 432,402 | |||||||
| Allowance for doubtful accounts | 25,762 | 64,057 | ||||||
| $ | 465,195 | $ | 368,345 | |||||
Receivables consist of the following:
| October 31, 2003 | April 30, 2003 | |||||||
| Business Services accounts receivable | $ | 154,143 | $ | 185,023 | ||||
| Mortgage loans held for sale | 100,174 | 68,518 | ||||||
| Loans to franchisees | 39,370 | 33,341 | ||||||
| Refund anticipation loans (RALs) and related receivables | 17,200 | 12,871 | ||||||
| Software receivables | 1,522 | 36,810 | ||||||
| Other | 50,886 | 89,054 | ||||||
| 363,295 | 425,617 | |||||||
| Allowance for doubtful accounts | (12,678 | ) | (17,038 | ) | ||||
| Lower of cost or market adjustment | (9,823 | ) | (5,382 | ) | ||||
| $ | 340,794 | $ | 403,197 | |||||
-6-
| 5. | ||
-5-Activity related to residual interests in securitizations for the six months ended October 31, 2003 and 2002 and the twelve months ended April 30, 2003 consists of the following:
| Six Months Ended | Year Ended | |||||||||||
| October 31, 2003 | October 31, 2002 | April 30, 2003 | ||||||||||
| Balance, beginning of period | $ | 264,337 | $ | 365,371 | $ | 365,371 | ||||||
| Additions from NIM transactions | 1,814 | 753 | 753 | |||||||||
| Additions from secured financing, held as collateral | 40,196 | — | — | |||||||||
| Cash received | (68,850 | ) | (103,885 | ) | (140,795 | ) | ||||||
| Cash received on sales of residual interests | — | — | (142,486 | ) | ||||||||
| Accretion | 70,906 | 92,853 | 145,165 | |||||||||
| Impairments of fair value | (11,106 | ) | (24,132 | ) | (54,111 | ) | ||||||
| Exercise of call option | (2,603 | ) | — | — | ||||||||
| Changes in unrealized holding gains arising during the period, net | 22,910 | 55,796 | 90,440 | |||||||||
| Balance, end of period | $ | 317,604 | $ | 386,756 | $ | 264,337 | ||||||
The Company sold $11,631,790 and $7,813,332 of mortgage loans in whole loan sales to third-party trusts (Trusts) during the six months ended October 31, 2003 and 2002, respectively, with gains totaling $424,034 and $320,517, respectively, recorded on these sales.
Residual interests valued at $199,021 and $136,766 were securitized in net interest margin (NIM) transactions during the respective six-month periods. Net cash proceeds of $147,107 and $136,013 were received from the NIM transactions for the six months ended October 31, 2003 and 2002, respectively. Additional cash proceeds of $50,100 were received as a result of the secured financing, as described below. Total net additions to residual interests from NIM transactions for the six months ended October 31, 2003 and 2002 were $1,814 and $753, respectively.
In the second quarter of fiscal year 2004, the Company completed a NIM transaction with a special purpose entity (SPE) that did not qualify as a qualifying special purpose entity (QSPE), and therefore the SPE has been consolidated and the transaction is being accounted for as a secured financing (on-balance sheet securitization). As a result of the on-balance sheet securitization, the condensed consolidated balance sheet includes a residual interest of $40,196, which is held as collateral for the related financing, and an interest rate cap, which is a derivative instrument. The residual interest is accounted for as a trading security. The interest rate cap of $9,904 is included in other assets. Additionally, a liability for the principal balance of the bonds issued by the NIM trust of $50,100 has been included in other noncurrent liabilities on the condensed consolidated balance sheet.
The residual interest and interest rate cap underlying the bonds are owned by the NIM trust and are not available to the Company’s creditors. As such, the bondholders have no recourse to the Company for the failure of the underlying mortgage loan borrowers to pay when due. The
-7-
| Nine Months Ended | Year Ended | ||||||||||||
| January 31, | January 31, | April 30, | |||||||||||
| 2003 | 2002 | 2002 | |||||||||||
| Balance, beginning of year | $ | 365,371 | $ | 238,600 | $ | 238,600 | |||||||
| Additions | 753 | 13,694 | 26,057 | ||||||||||
| Cash received | (260,008 | ) | (33,006 | ) | (67,070 | ) | |||||||
| Accretion | 113,146 | 29,297 | 50,583 | ||||||||||
| Adjustments to fair value | (25,589 | ) | (29,642 | ) | (30,987 | ) | |||||||
| Changes in unrealized holding gains (losses) arising during the period: | |||||||||||||
| Gross unrealized holding gains | 162,548 | 58,557 | 151,141 | ||||||||||
| Gross unrealized holding losses | (12,609 | ) | — | — | |||||||||
| Less: realized (gains) losses | (69,259 | ) | (11,301 | ) | (2,953 | ) | |||||||
| Balance, end of period | $ | 274,353 | $ | 266,199 | $ | 365,371 | |||||||
interest rate cap is held for the benefit of the underlying bondholders of the NIM bonds to mitigate risk associated with the residual cash flows.
Cash flows of $68,850 and $103,885 were received from the securitization trusts for the six months ended October 31, 2003 and 2002, respectively. Cash received on residual interests is included in investing activities in the condensed consolidated statements of cash flows.
Residual interests are classified as either available-for-sale (AFS) or trading securities and are therefore reported at fair market value (based on discounted cash flow models). Unrealized holding gains represent the write-up of AFS residual interests as a result of actual or estimated lower interest rates, loan losses or loan prepayments than previously projected in the Company’s valuation models. Trading securities are marked-to-market through the income statement.
Aggregate net unrealized gains on residual interests, which had not yet been accreted into income, totaled $120,903 at October 31, 2003 and $98,089 at April 30, 2003. These unrealized gains are recorded net of deferred taxes in other comprehensive income, and may be recognized in income in future periods either through accretion or upon further securitization or sale of the related residual interest.
In connection with securitization transactions, the Company, as servicer, has a 10% call option, whereby the Company, at its discretion, may repurchase the outstanding loans in the securitization once the current value of the loans is 10% or less of their original value. During the quarter ended July 31, 2003, the Company, as servicer, exercised its 10% call option on a residual interest originally recorded in 1996. The remaining outstanding loans were repurchased from the securitization trust, and the proceeds were used to pay off the remaining bondholders. These repurchased loans may be included in future sale transactions. At the time the call option was exercised, the book value of the residual interest was $2,603.
Activity related to mortgage servicing rights (MSRs) consists of the following:
| Six Months Ended | Year Ended | |||||||||||
| October 31, 2003 | October 31, 2002 | April 30, 2003 | ||||||||||
| Balance, beginning of period | $ | 99,265 | $ | 81,893 | $ | 81,893 | ||||||
| Additions | 48,002 | 37,968 | 65,345 | |||||||||
| Amortization | (35,307 | ) | (20,087 | ) | (47,107 | ) | ||||||
| Impairments of fair value | — | — | (866 | ) | ||||||||
| Balance, end of period | $ | 111,960 | $ | 99,774 | $ | 99,265 | ||||||
-8-
The key assumptions the Company utilized to originally estimate the cash flows and values of residual interests for securitizations during the three months ended October 31, 2003 are as follows:
| Estimated annual prepayments | 30% to 90% | ||||
| Estimated credit losses | 4.74% | ||||
| Discount rate — residual interests | 13.21% to 18.19% | ||||
| Variable returns to third-party | LIBOR forward curve | ||||
| holders | |||||
-6-The following table illustrates key assumptions the Company utilizes to estimate the cash flows and values of residual interests and MSRs at October 31, 2003:
| Estimated annual prepayments | ||||||
| Estimated credit losses | ||||||
| Discount rate — residual interests | 12% to | |||||
| Discount rate — MSRs | ||||||
| Residential Mortgage Loans | |||||||||||||
| Cross- | NIM | Servicing | |||||||||||
| Collateralized | Residuals | Asset | |||||||||||
| Carrying amount/fair value of residuals | $ | 54,682 | $ | 219,671 | $ | 104,580 | |||||||
| Weighted average life (in years) | 6.5 | 2.3 | 1.6 | ||||||||||
| Prepayments (including defaults): | |||||||||||||
| Adverse 10% — $impact on fair value | $ | (279 | ) | $ | (40,688 | ) | $ | (16,309 | ) | ||||
| Adverse 20% — $impact on fair value | (388 | ) | (47,445 | ) | (32,869 | ) | |||||||
| Credit losses: | |||||||||||||
| Adverse 10% — $impact on fair value | $ | (1,285 | ) | $ | (25,078 | ) | Not applicable | ||||||
| Adverse 20% — $impact on fair value | (2,604 | ) | (48,841 | ) | Not applicable | ||||||||
| Discount rate: | |||||||||||||
| Adverse 10% — $impact on fair value | $ | (3,101 | ) | $ | (7,661 | ) | $ | (1,686 | ) | ||||
| Adverse 20% — $impact on fair value | (5,975 | ) | (14,584 | ) | (3,321 | ) | |||||||
| Variable interest rates: | |||||||||||||
| Adverse 10% — $impact on fair value | $ | (292 | ) | $ | (19,921 | ) | Not applicable | ||||||
| Adverse 20% — $impact on fair value | (489 | ) | (40,188 | ) | Not applicable | ||||||||
These sensitivities are hypothetical and should be used with caution. As the table indicates, changes in fair value based on a 10% variation in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in fair value may not be -9- linear. Also in this table, the effect of a variation of a particular assumption on the fair value of the retained interest is calculated without changing any other assumptions. It is likely that changes in one factor may result in changes in another, which might magnify or counteract the sensitivities. | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
-7-
| 6. | Intangible Assets and Goodwill | |
| January 31, 2003 | April 30, 2002 | ||||||||||||||||
| Gross | Gross | ||||||||||||||||
| Carrying | Accumulated | Carrying | Accumulated | ||||||||||||||
| Amount | Amortization | Amount | Amortization | ||||||||||||||
| Investment Services | |||||||||||||||||
| Customer relationships | $ | 293,000 | $ | (92,783 | ) | $ | 293,000 | $ | (70,808 | ) | |||||||
| Business Services | |||||||||||||||||
| Customer relationships | 118,910 | (41,161 | ) | 116,814 | (31,881 | ) | |||||||||||
| Noncompete agreements | 27,039 | (5,517 | ) | 26,387 | (3,624 | ) | |||||||||||
| Trade name — amortizing | 1,451 | (169 | ) | 2,428 | — | ||||||||||||
| Trade name — non-amortizing | 55,637 | (4,868 | ) | 55,637 | (4,868 | ) | |||||||||||
| Corporate Operations | |||||||||||||||||
| Customer relationships | 172 | (4 | ) | — | — | ||||||||||||
| Noncompete agreements | 60 | (1 | ) | — | — | ||||||||||||
| Total intangible assets | $ | 496,269 | $ | (144,503 | ) | $ | 494,266 | $ | (111,181 | ) | |||||||
Intangible assets consist of the following:
| October 31, 2003 | April 30, 2003 | ||||||||||||||||
| Gross | Gross | ||||||||||||||||
| Carrying | Accumulated | Carrying | Accumulated | ||||||||||||||
| Amount | Amortization | Amount | Amortization | ||||||||||||||
| U.S. Tax Operations: | |||||||||||||||||
| Customer relationships | $ | 21,362 | $ | (855 | ) | $ | — | $ | — | ||||||||
| Noncompete agreements | 10,031 | (859 | ) | — | — | ||||||||||||
| Business Services: | |||||||||||||||||
| Customer relationships | 120,178 | (50,421 | ) | 120,178 | (44,192 | ) | |||||||||||
| Noncompete agreements | 26,909 | (7,447 | ) | 26,909 | (6,157 | ) | |||||||||||
| Trade name — amortizing | 1,450 | (277 | ) | 1,450 | (205 | ) | |||||||||||
| Trade name — non-amortizing | 55,637 | (4,868 | ) | 55,637 | (4,868 | ) | |||||||||||
| Investment Services: | |||||||||||||||||
| Customer relationships | 293,000 | (114,758 | ) | 293,000 | (100,108 | ) | |||||||||||
| Corporate Operations: | |||||||||||||||||
| Customer relationships | 844 | (24 | ) | 172 | (10 | ) | |||||||||||
| Noncompete agreements | 295 | (9 | ) | 60 | (1 | ) | |||||||||||
| Total intangible assets | $ | 529,706 | $ | (179,518 | ) | $ | 497,406 | $ | (155,541 | ) | |||||||
Amortization of intangible assets for the three and six months ended October 31, 2003 was $12,861 and $23,977, respectively. Amortization of intangible assets for the three and six months ended October 31, 2002 was $10,966 and $22,285, respectively. Estimated amortization of intangible assets for fiscal years 2004 through 2008 is $51,384, $50,556, $49,559, $42,988 and $41,218, respectively.
Changes in the carrying amount of goodwill for the six months ended October 31, 2003, consist of the following:
| April 30, 2003 | Additions | Other | October 31, 2003 | |||||||||||||
| U.S. Tax Operations | $ | 130,502 | $ | 88,892 | $ | — | $ | 219,394 | ||||||||
| Mortgage Operations | 152,467 | — | — | 152,467 | ||||||||||||
| Business Services | 279,650 | 25,832 | — | 305,482 | ||||||||||||
| Investment Services | 145,732 | — | — | 145,732 | ||||||||||||
| International Tax Operations | 5,666 | 512 | 591 | 6,769 | ||||||||||||
| Corporate Operations | 198 | 11 | — | 209 | ||||||||||||
| Total goodwill | $ | 714,215 | $ | 115,247 | $ | 591 | $ | 830,053 | ||||||||
-10-
Additions to goodwill for U.S. Tax Operations include $83,267 related to asset acquisitions involving former major franchise businesses and other acquisitions of $5,625. Additions to goodwill for Business Services primarily result from the last contingent payment related to the acquisition of the non-attest assets of McGladrey & Pullen, LLP of approximately $25,000.
The Company tests goodwill for impairment annually, or more frequently if events occur which indicate a potential reduction in the fair value of a reporting unit’s net assets below its carrying value. During the six months ended October 31, 2002, a goodwill impairment charge of $24,000 was recorded for the Investment Services segment. No such impairment or events indicating potential impairment have been identified within any of the Company’s segments during the six months ended October 31, 2003.
| April 30, | January 31, | |||||||||||||||
| 2002 | Additions | Other | 2003 | |||||||||||||
| U.S. Tax Operations | $ | 128,745 | $ | 1,306 | $ | — | $ | 130,051 | ||||||||
| International Tax Operations | 5,287 | — | 47 | 5,334 | ||||||||||||
| Mortgage Operations | 152,467 | — | — | 152,467 | ||||||||||||
| Investment Services | 169,732 | — | (24,000 | ) | 145,732 | |||||||||||
| Business Services | 267,625 | 21,373 | 1,979 | 290,977 | ||||||||||||
| Corporate Operations | — | 198 | — | 198 | ||||||||||||
| Total goodwill | $ | 723,856 | $ | 22,877 | $ | (21,974 | ) | $ | 724,759 | |||||||
-8-The Company, in the normal course of business, enters into commitments with its customers to fund mortgage loans for specified periods of time at “locked-in” interest rates. These financial instruments represent commitments (rate-lock equivalent) to fund loans. The estimated fair value of these rate-lock equivalents is determined based on the difference in the value of the commitments to fund loans between the date of commitment and the date of valuation, taking into consideration the probability of the commitments being exercised and changes in other market conditions. At October 31, 2003 and April 30, 2003, the Company recorded assets totaling $13,144 and $12,531, respectively, in prepaid expenses and other current assets on the condensed consolidated balance sheets related to these commitments.
The Company entered into an agreement with Household Tax Masters, Inc. (Household) during fiscal year 2003, whereby the Company waived its right to purchase any participation interests in and receive license fees relating to RALs during the period January 1 through April 30, 2003. In consideration for waiving these rights, the Company received a series of payments from Household, subject to certain adjustments based on delinquency rates on RALs made by Household through December 31, 2003. The adjustment to the payments will be paid in January 2004. This adjustment is a derivative and will be marked-to-market monthly through December 31, 2003. During the three and six months ended October 31, 2003, the Company recognized $1,446 and $5,560, respectively, of revenues related to this instrument. A receivable of $10,731 and $5,171 is included on the condensed consolidated balance sheet as of October 31, 2003 and April 30, 2003, respectively.
-9-
-10--11-
| 8. | ||
| Three months ended | Nine months ended | ||||||||||||||||
| January 31, | January 31, | ||||||||||||||||
| 2003 | 2002 | 2003 | 2002 | ||||||||||||||
| Revenues: | |||||||||||||||||
| U.S. Tax Operations | $ | 403,571 | $ | 371,874 | $ | 460,286 | $ | 418,915 | |||||||||
| International Tax Operations | 8,779 | 7,977 | 28,388 | 26,450 | |||||||||||||
| Mortgage Operations | 396,980 | 179,751 | 921,874 | 508,897 | |||||||||||||
| Investment Services | 48,047 | 61,085 | 156,737 | 194,837 | |||||||||||||
| Business Services | 100,741 | 107,061 | 293,938 | 279,866 | |||||||||||||
| Corporate Operations | 295 | 5,784 | (48 | ) | 7,444 | ||||||||||||
| $ | 958,413 | $ | 733,532 | $ | 1,861,175 | $ | 1,436,409 | ||||||||||
| Earnings (loss) from: | |||||||||||||||||
| U.S. Tax Operations | $ | 34,137 | $ | 25,280 | $ | (212,192 | ) | $ | (160,113 | ) | |||||||
| International Tax Operations | (5,735 | ) | (5,242 | ) | (12,436 | ) | (11,886 | ) | |||||||||
| Mortgage Operations | 262,466 | 77,427 | 563,071 | 237,397 | |||||||||||||
| Investment Services | (31,755 | ) | (12,300 | ) | (92,488 | ) | (27,533 | ) | |||||||||
| Business Services | (4,197 | ) | 1,780 | (12,255 | ) | 2,163 | |||||||||||
| Corporate Operations | (13,968 | ) | (17,928 | ) | (33,927 | ) | (29,068 | ) | |||||||||
| Interest expense — acquisition debt | (18,014 | ) | (19,243 | ) | (54,990 | ) | (60,001 | ) | |||||||||
| Earnings (loss) before income taxes | $ | 222,934 | $ | 49,774 | $ | 144,783 | $ | (49,041 | ) | ||||||||
The Company’s comprehensive income is comprised of net income (loss), the change in net unrealized gain on marketable securities and foreign currency translation adjustments. The components of comprehensive income (loss) for the three and six months ended October 31, 2003 and 2002 were:
| Three months ended | Six months ended | |||||||||||||||
| October 31, | October 31, | |||||||||||||||
| 2003 | 2002 | 2003 | 2002 | |||||||||||||
| Net income (loss) | $ | 10,376 | $ | (37,347 | ) | $ | 15,536 | $ | (46,891 | ) | ||||||
| Change in net unrealized gain on marketable securities | (6,172 | ) | 450 | 14,036 | 34,200 | |||||||||||
| Change in foreign currency translation adjustments | 6,087 | 1,289 | 11,730 | 771 | ||||||||||||
| Comprehensive income (loss) | $ | 10,291 | $ | (35,608 | ) | $ | 41,302 | $ | (11,920 | ) | ||||||
| 9. | ||
-11-
-12-
| Three Months Ended | Six Months Ended | ||||||||||||||||
| October 31, | October 31, | ||||||||||||||||
| 2003 | 2002 | 2003 | 2002 | ||||||||||||||
| Net income (loss) as reported | $ | 10,376 | $ | (37,347 | ) | $ | 15,536 | $ | (46,891 | ) | |||||||
| Add: Stock-based compensation expense included in reported net income, net of related tax effects | 2,005 | 310 | 2,797 | 532 | |||||||||||||
| Deduct: Total stock-based compensation expense determined under fair value method for all awards, net of related tax effects | (5,565 | ) | (5,586 | ) | (10,631 | ) | (12,214 | ) | |||||||||
| Pro forma net income (loss) | $ | 6,816 | $ | (42,623 | ) | $ | 7,702 | $ | (58,573 | ) | |||||||
| Basic earnings (loss) per share: | |||||||||||||||||
| As reported | $ | .06 | $ | (.21 | ) | $ | .09 | $ | (.26 | ) | |||||||
| Pro forma | .04 | (.24 | ) | .04 | (.33 | ) | |||||||||||
| Diluted earnings (loss) per share: | |||||||||||||||||
| As reported | $ | .06 | $ | (.21 | ) | $ | .09 | $ | (.26 | ) | |||||||
| Pro forma | .04 | (.24 | ) | .04 | (.33 | ) | |||||||||||
| 10. |
During the six months ended October 31, 2003, the Company paid $170,826 and $42,724 for income taxes and interest, respectively. During the six months ended October 31, 2002, the Company paid $124,844 and $39,927 for income taxes and interest, respectively.
During the six months ended October 31, 2003 and 2002, the Company treated the following as non-cash investing activities:
| Six months ended October 31, | ||||||||
| 2003 | 2002 | |||||||
| Additions to residual interests | $ | 1,814 | $ | 753 | ||||
| Residual interest mark-to-market | 22,910 | 55,796 | ||||||
| Accrued payment on acquisition debt | 25,000 | — | ||||||
| 11. |
Commitments and Contingencies
The Company offers separately priced guarantees under its Peace of Mind guarantee program to tax clients whereby the Company will assume the cost of additional tax assessments attributable to tax return preparation error. The Company defers the revenue and expenses associated with these guarantees, and recognizes these amounts over the term of the guarantee based upon historical claims data. The related current asset and liability are not subject to a stated limit. The Company estimates the potential payments (undiscounted) total approximately $52,619 as of January 31, 2003. The Company's estimate is based on current financial conditions. Should actual results differ materially from the Company's assumptions, the potential payments will differ from the above estimate. Such payments, if and when paid, would be recorded as additional goodwill.
| Nine Months Ended | Year Ended | |||||||||||
| January 31, | April 30, | |||||||||||
| 2003 | 2002 | 2002 | ||||||||||
| Balance, beginning of year | $ | 44,982 | $ | 31,483 | $ | 31,483 | ||||||
| Amounts deferred for new warranties issued | 7,592 | 7,865 | 28,945 | |||||||||
| Revenue recognized on previous deferrals | (17,809 | ) | (10,704 | ) | (15,446 | ) | ||||||
| Balance, end of period | $ | 34,765 | $ | 28,644 | $ | 44,982 | ||||||
-13-
condensed consolidated balance sheets. The related noncurrent asset and liability are included in other assets and other noncurrent liabilities, respectively, on the condensed consolidated balance sheets. During the three months ended October 31, 2003, the Company adopted EITF 00-21 and recorded a cumulative effect of a change in accounting principle as of May 1, 2003. See further discussion in note 13. Changes in the deferred revenue liability for the six months ended October 31, 2003 and 2002 and the twelve months ended April 30, 2003 are as follows:
| Six Months Ended | Year Ended | |||||||||||
| October 31, | April 30, | |||||||||||
| 2003 | 2002 | 2003 | ||||||||||
| Balance, beginning of period | $ | 49,280 | $ | 44,982 | $ | 44,982 | ||||||
| Amounts deferred for new guarantees issued | 975 | 193 | 28,854 | |||||||||
| Revenue recognized on previous deferrals | (37,558 | ) | (14,131 | ) | (24,556 | ) | ||||||
| Adjustment resulting from change in accounting principle | 61,487 | — | — | |||||||||
| Balance, end of period | $ | 74,184 | $ | 31,044 | $ | 49,280 | ||||||
Option One Mortgage Corporation provides a guarantee up to a maximum amount equal to approximately 10% of the aggregate principal balance of mortgage loans held by the Trusts (qualifying special purpose entities) before ultimate disposition of the loans by the Trusts. This guarantee would be called upon in the event adequate proceeds were not available from the sale of the mortgage loans to satisfy the current or ultimate payment obligations of the Trusts. No losses have been sustained on this commitment since its inception. The total principal amount of Trust obligations outstanding as of October 31, 2003 and April 30, 2003 was $3,811,085 and $2,176,286, respectively. The fair value of mortgage loans held by the Trusts as of October 31, 2003 and April 30, 2003 was approximately $3,960,000 and $2,273,000, respectively. At October 31, 2003 and April 30, 2003, a liability, which represents the estimated value of the 10% guarantee, of $10,256 and $6,175, respectively, was recorded in accounts payable, accrued expenses and other on the condensed consolidated balance sheets.
The Company manages its interest rate risk by entering into forward loan sale commitments to be settled at a future date. The Company had commitments to sell loans of $5,310,000 and $1,470,031 as of October 31, 2003 and April 30, 2003, respectively.
The Company has entered into whole loan sale agreements with investors in the normal course of business, which include standard representations and warranties customary to the mortgage banking industry. Violations of these representations and warranties may require the Company to repurchase loans previously sold. A liability has been established related to the potential loss on repurchase of loans previously sold of $28,682 and $18,859 at October 31, 2003 and April 30, 2003, respectively. This liability is included in accounts payable, accrued expenses and other on the condensed consolidated balance sheets. Repurchased loans are normally sold in subsequent sale transactions.
The Company and its subsidiaries have various contingent purchase price obligations in connection with prior acquisitions. In many cases, contingent payments to be made in
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connection with these acquisitions are not subject to a stated limit. The Company estimates the potential payments (undiscounted) total approximately $8,750 and $52,290 as of October 31, 2003 and April 30, 2003, respectively. The Company’s estimate is based on current financial conditions. Should actual results differ materially from the Company’s assumptions, the potential payments will differ from the above estimate. Such payments, if and when paid, would be recorded as additional goodwill.
The Company has contractual commitments to fund certain franchises requesting draws on Franchise Equity Lines of Credit (FELCs). The commitment to fund FELCs as of October 31, 2003 and April 30, 2003 totaled $60,307 and $56,070, respectively, with a related receivable balance of $39,370 and $33,341, respectively, included on the condensed consolidated balance sheets. The receivable represents the amount drawn on the FELCs as of October 31, 2003 and April 30, 2003.
The Company and its subsidiaries also routinely enter into contracts that include embedded indemnifications that have characteristics similar to guarantees. Other guarantees and indemnifications of the Company and its subsidiaries include obligations to protect counter parties from losses arising from the following: a) tax, legal and other risks related to the purchase or disposition of businesses; b) penalties and interest assessed by Federal and state taxing authorities in connection with tax returns prepared for clients; c) indemnification of the Company’s directors and officers; and d) third-party claims relating to various arrangements in the normal course of business. Typically, there is no stated maximum payment related to these indemnifications, and the term of indemnities may vary and in many cases is limited only by the applicable statute of limitations. The likelihood of any claims being asserted against the Company or its subsidiaries and the ultimate liability related to any such claims, if any, is difficult to predict. While management cannot provide assurance the Company and its subsidiaries will ultimately prevail in the event any such claims are asserted, management believes the fair value of these guarantees and indemnifications is not material as of October 31, 2003.
Litigation
In November 2002, the Company and a major franchisee of a subsidiary of the Company, reached an agreement with the plaintiff class in the class action lawsuit entitledRonnie and Nancy Haese, et al. v. H&R Block, Inc. et al., Case No. CV96-423, in the District Court of Kleberg County, Texas, related to RALs. The settlement provides a five-year package of coupons class members can use to obtain a variety of tax preparation and tax planning services from the Company’s subsidiaries. The Company’s major franchisee, which operates more than half of all H&R Block offices in Texas, will share a portion of the total settlement cost. As a result, the Company recorded a liability and pretax expense of $41,672, during the second quarter of fiscal year 2003, which, at the time, represented the Company’s best estimate of its share of the settlement cost for plaintiff class legal fees and expenses, tax products and associated mailing expenses. The settlement was approved by the court as a part of a final judgment entered on June 24, 2003. No appeals of the judgment and award were filed. The Company paid the award of $49,900 of attorneys’ fees and expenses to class counsel on August 22, 2003. In addition to the liability that has already been recorded and/or paid, the Company will reduce revenues associated with tax
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preparation services as the coupons are redeemed each year. Distribution of the settlement coupons was made following the end of the second quarter.
The Company has been involved in a number of other putative RAL class action cases since 1990 and has successfully defended many cases. In order to avoid the uncertainty of litigation and the diversion of resources and personnel resulting from the lawsuits, the Company, the lending bank, and the plaintiffs in the caseJoel E. Zawikowski, et al. v. Beneficial National Bank, H&R Block, Inc., et al.(renamedLynne A. Carnegie, et al. v. H&R Block, Inc., et al.), Case No. 98-C-2178 in the United States District Court for Northern Illinois, had agreed to a settlement class and a settlement of RAL-related claims on a nationwide basis. Under that settlement, the Company and the lending bank agreed to each pay $12,500 toward a $25,000 settlement fund for the benefit of the class members. The settlement was approved by the District Court in February 2001 and the defendants paid the $25,000 into an escrow fund. Certain class members who had objected to the settlement appealed the order approving the settlement to the Seventh Circuit Court of Appeals. In April 2002, the Court of Appeals reversed the District Court’s order approving the settlement and remanded the matter back to the District Court for further consideration of the fairness and adequacy of the proposed settlement by a new District Court judge. In April 2003, the District Court judge declined to approve the $25,000 settlement, finding that counsel for the settlement plaintiffs had been inadequate representatives of the plaintiff class and failed to sustain their burden of showing that the settlement was fair. The judge appointed new counsel for the plaintiffs in the first quarter of fiscal year 2004 and named their client, Lynne A. Carnegie, as lead plaintiff. The new counsel for the plaintiffs have since filed an amended complaint and a motion for partial summary judgment. The defendants have filed a motion to dismiss, a brief in response to allegations in the plaintiffs’ amended complaint relating to class certification, and responses to plaintiffs’ motion for partial summary judgment. The Company recorded a receivable in the amount of its $12,500 share of the settlement fund in the fourth quarter of fiscal year 2003 and recorded a reserve in such quarter of $12,500 consistent with the existing settlement authority of the Board of Directors. The defendants requested the release of the escrowed settlement fund and the $12,500 was received during the second quarter of fiscal year 2004. The Company intends to defend the case and the remaining RAL class action litigation vigorously and there are no assurances that any of the matters will result in settlements or as to the amount of any settlement.
The Company and certain of its current and former officers and directors are named defendants in litigation entitledPaul White, et al. v. H&R Block, et al.,consolidated Case Numbers 02CV8965, 02CV9661, 02CV9682 and 02CV9830 pending in the United States District Court for the Southern District of New York since the third quarter of fiscal year 2003. The respective named plaintiffs seek to represent a class of shareholders who purchased the Company’s stock between November 8, 1997 and November 6, 2002, and allege that the defendants violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder by failing to disclose to shareholders various cases in which the Company had been sued regarding the RAL program, by failing to set adequate reserves for those cases, and by failing to disclose the supposed implications of those cases for the future of the RAL program. The four securities law cases were all assigned to the same judge and consolidated for pre-trial matters. A consolidated complaint was filed in March 2003 and the defendants responded by filing a motion to dismiss in
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April 2003. In response to defendants’ motion to dismiss, the plaintiffs informed defendants that they wished further to amend their complaint. Defendants consented to the filing of an amended complaint as a pleading matter, the plaintiffs filed the amended complaint, and the defendants filed a motion to dismiss it in August 2003. The Company believes the claims in these actions are without merit, and intends to defend them vigorously.
The Company is a named defendant in litigation entitledWilliam R. Smith, Inc., et al. v. H&R Block, Inc., et al., Case No. 99-CV-206379, pending in the Circuit Court of Jackson County, Missouri (previously known asArmstrong Business Services, Inc., et al. v. H&R Block, Inc., et al.). The action was filed by “major” franchisees against the Company and certain of its subsidiaries relating to alleged breaches of contract and other matters. The Company’s subsidiary, HRB Royalty, Inc., the franchisor under the applicable franchise agreements, filed a counterclaim and subsequently a motion for summary judgment seeking a declaration that HRB Royalty, Inc. could elect not to renew the major franchise agreements when the then current five-year terms came to an end. Such motion for summary judgment was granted in March 2001 and upheld on appeal. HRB Royalty notified the plaintiff major franchisees in 2000 that it did not intend to renew their franchise agreements at the expiration of the then current renewal terms and that the agreements would terminate at those times. The renewal dates varied among the franchisees. Pursuant to the franchise agreements, HRB Royalty must pay a “fair and equitable price” to the franchisee for the franchisee’s franchise business, and such price must be no less than 80% of the franchisee’s revenues for the most recent 12 months ended April 30, plus the value of equipment and supplies, and certain off-season expenses. The Circuit Court ruled in May 2003 that major franchise agreements with renewal terms scheduled to expire prior to July 1, 2003, will expire on July 1, 2003, and other major franchise agreements will expire as the renewal terms expire commencing in September 2003 and ending in fiscal year 2005. The Court ordered defendants to pay for the franchise businesses as provided in the franchise agreements on the applicable dates of expiration. During the six months ended October 31, 2003, franchise agreements of twelve major franchisees expired and subsidiaries of the Company acquired and began operating tax preparation businesses as company-owned operations in the franchise territories of ten former major franchisees. With respect to the two other franchisees with expired franchise agreements, one franchisee entered into a new franchise agreement with a limited term and one franchisee continued litigation challenging the expiration of the franchise agreement. Cash payments of $118,828 were made or accrued related to these former major franchises during the six months ended October 31, 2003.
InSmith, plaintiffs’ claims against the Company and its subsidiaries remain in the trial court. In their second amended petition, the plaintiffs seek in excess of $20,000 in actual damages, punitive damages, unspecified statutory damages, declaratory, injunctive and other relief, including attorneys’ fees under allegations of breach of contract, breach of the covenant of good faith and fair dealing, unfair business practices, state anti-trust violations, breach of fiduciary duty, prima facie tort, violations of various state franchise statutes, fraud and misrepresentation, waiver and estoppel, ambiguity and reformation, relief with respect to a post-termination covenant not to compete in the franchise agreements, and a request for a fair and equitable payment upon nonrenewal of the franchise agreements. The major franchisees allege, among other things, that the sale of TaxCut® income tax return preparation software and online tax
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services and the purchase of accounting firms encroached on their exclusive franchise territories. The defendants believe that the allegations against them are without merit and continue to defend the case vigorously. Management believes that amounts, if any, required to be paid by the Company and its subsidiaries in the discharge of liabilities or settlements relating to these claims of the plaintiffs in this litigation will not have a material adverse effect on the Company’s consolidated results of operations, cash flows or financial position.
In August 2003, a subsidiary of the Company entered into a transaction with one of the former major franchisees whose franchise agreements expired in the first quarter, pursuant to which such subsidiary acquired the stock of the franchisee and the franchisee released the Company and its affiliates from any further liability regarding additional payments under the major franchise agreements. With the exceptions of the former franchisee that executed a release and the franchisee that entered into a new franchise agreement, the court will determine if any additional payments are required for these franchise businesses.
The first trial involving one of the plaintiffs in theSmithlitigation was held in October 2003. At the conclusion of this trial, the jury rendered a verdict and the court entered a judgment requiring the Company to make an additional payment of $3,197 for the franchise business. As of October 31, 2003, the Company recorded this liability in accounts payable, accrued expenses and other on the condensed consolidated balance sheet. The original payment for the franchise business made in the first quarter of fiscal year 2004 was $4,955. This trial also involved the issues relating to that plaintiff’s claims for damages against the Company. The jury rendered a verdict of $921 in favor of the plaintiff on the plaintiff’s claims against the Company. The outcome of the trial is subject to post-trial motions and possible appeals. The next trial to take place as a part of theSmithlitigation is scheduled for May 2004.
In addition to the aforementioned cases, the Company and its subsidiaries have from time to time been party to claims and lawsuits arising out of such subsidiaries’ business operations, including other claims and lawsuits relating to RALs, and claims and lawsuits concerning the preparation of customers’ income tax returns, the electronic filing of income tax returns, the fees charged customers for various services, the Peace of Mind guarantee program associated with income tax return preparation services, relationships with franchisees and contract disputes. Such lawsuits include actions by individual plaintiffs, as well as cases in which plaintiffs seek to represent a class of similarly situated customers. The amounts claimed in these claims and lawsuits are substantial in some instances, and the ultimate liability with respect to such litigation and claims is difficult to predict. The Company’s management considers these cases to be ordinary, routine litigation incidental to its business, believes the Company and its subsidiaries have meritorious defenses to each of them and is defending, or intends to defend, them vigorously. While management cannot provide assurance the Company and its subsidiaries will ultimately prevail in each instance, management believes that amounts, if any, required to be paid by the Company and its subsidiaries in the discharge of liabilities or settlements will not have a material adverse effect on the Company’s consolidated results of operations, cash flows or financial position. Regardless of outcome, claims and litigation can adversely affect the Company and its subsidiaries due to defense costs, diversion of management and publicity related to such matters.
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It is the Company’s policy to accrue for amounts related to legal matters if it is probable that a liability has been incurred and an amount is reasonably estimable. Many of the various legal proceedings are covered in whole, or in part, by insurance.
| Segment Information |
Information concerning the Company’s operations by reportable operating segment for the three and six months ended October 31, 2003 and 2002 is as follows:
| Three months ended | Six months ended | ||||||||||||||||||||
| July 31, | October 31, | October 31, | October 31, | ||||||||||||||||||
| 2003 | 2003 | 2002 | 2003 | 2002 | |||||||||||||||||
| Revenues: | |||||||||||||||||||||
| U.S. Tax Operations | $ | 40,522 | $ | 47,189 | $ | 33,429 | $ | 87,711 | $ | 56,715 | |||||||||||
| Mortgage Operations | 302,895 | 351,156 | 274,588 | 654,051 | 524,894 | ||||||||||||||||
| Business Services | 98,499 | 109,024 | 97,883 | 207,523 | 193,197 | ||||||||||||||||
| Investment Services | 56,987 | 52,703 | 50,027 | 109,690 | 108,690 | ||||||||||||||||
| International Tax Operations | 5,459 | 19,095 | 15,326 | 24,554 | 19,609 | ||||||||||||||||
| Corporate Operations | 1,328 | 688 | 143 | 2,016 | (343 | ) | |||||||||||||||
| $ | 505,690 | $ | 579,855 | $ | 471,396 | $ | 1,085,545 | $ | 902,762 | ||||||||||||
| Income (loss) from: | |||||||||||||||||||||
| U.S. Tax Operations | $ | (93,172 | ) | $ | (130,938 | ) | $ | (152,299 | ) | $ | (224,110 | ) | $ | (246,329 | ) | ||||||
| Mortgage Operations | 163,829 | 184,026 | 153,520 | 347,855 | 300,605 | ||||||||||||||||
| Business Services | (6,679 | ) | (2,732 | ) | (3,785 | ) | (9,411 | ) | (8,058 | ) | |||||||||||
| Investment Services | (13,757 | ) | (15,336 | ) | (27,936 | ) | (29,093 | ) | (60,733 | ) | |||||||||||
| International Tax Operations | (6,408 | ) | 555 | (250 | ) | (5,853 | ) | (6,701 | ) | ||||||||||||
| Corporate Operations | (24,984 | ) | (18,441 | ) | (31,495 | ) | (43,425 | ) | (56,935 | ) | |||||||||||
| Income (loss) before taxes | $ | 18,829 | $ | 17,134 | $ | (62,245 | ) | $ | 35,963 | $ | (78,151 | ) | |||||||||
Results for the quarter ended July 31, 2003 have been restated for the adoption of EITF 00-21.
| 13. | New Accounting Pronouncements |
SFAS 149
In April 2003, Statement of Financial Accounting Standards No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (SFAS 149) was issued. SFAS 149 amends and clarifies the accounting for derivative instruments and incorporates many of the implementation issues cleared as a result of the Derivatives Implementation Group process. The provisions of this standard are effective for contracts entered into or modified after June 30, 2003. The adoption of this standard did not have a material impact on the Company’s consolidated financial statements.
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FIN 46
In January 2003, the Financial Accounting Standards Board (FASB) issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (FIN 46). FIN 46 provides guidance with respect to the consolidation of certain variable interest entities (VIEs) whereby a VIE must be consolidated by its primary beneficiary if the entity does not effectively disperse risks among parties involved. The primary beneficiary is one who absorbs a majority of the expected losses, residual returns, or both as a result of holding variable interests. FIN 46 also requires disclosures for both the primary beneficiary of a VIE and other parties with significant variable interests in the entity.
The provisions of FIN 46 apply immediately to VIEs created after January 31, 2003, and to VIEs in which an enterprise obtains an interest after that date. In October 2003, the FASB issued a staff position delaying the effective date of the consolidation requirements of FIN 46 under certain circumstances to periods ending on or after December 15, 2003 for entities created before February 1, 2003.
The Mortgage Operations segment has an interest in certain QSPEs it currently does not consolidate, which are exempt from the provisions of FIN 46. The Company is continuing its evaluation of interests in potential VIEs, and will continue to monitor additional guidance as provided by the FASB on this standard.
EITF 00-21
In August 2003, the Company adopted EITF 00-21. EITF 00-21 requires consideration received in connection with arrangements involving multiple revenue generating activities be measured and allocated to each separate unit of accounting in the arrangement. Revenue recognition is determined separately for each unit of accounting within the arrangement. EITF 00-21 impacts revenue and expense recognition related to tax preparation in the Company’s premium tax offices where Peace of Mind (POM) guarantees are included in the price of a completed tax return. Prior to the adoption of EITF 00-21, revenues and expenses related to POM guarantees at premium offices were recorded in the same period as tax preparation revenues. Beginning May 1, 2003, revenues and direct expenses related to POM guarantees are now initially deferred and recognized over the guarantee period in proportion to POM claims paid. As a result of the adoption of EITF 00-21, the Company recorded a cumulative effect of a change in accounting principle of $6,359, net of taxes of $4,031, as of May 1, 2003. The Company’s results of operations for the three months ended July 31, 2003 have been restated to reflect the cumulative effect of a change in accounting principle as of May 1, 2003 and to reflect the recognition of deferred revenues and expenses for the three months ended July 31, 2003.
Restated results for the three months ended July 31, 2003 and pro forma results, as if EITF 00-21 had been applied during each period, for the three months ended July 31, 2002 and October 31, 2002 and the six months ended October 31, 2002 are as follows:
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| Three months ended July 31, | ||||||||||||||||
| 2003 | 2002 | |||||||||||||||
| As reported | Restated | As reported | Pro forma | |||||||||||||
| Revenues | $ | 494,843 | $ | 505,690 | $ | 431,366 | $ | 442,757 | ||||||||
| Income (loss) before taxes | 17,297 | 18,829 | (15,906 | ) | (13,514 | ) | ||||||||||
| Net income (loss) before cumulative effect of change in accounting principle | 10,582 | 11,519 | (9,544 | ) | (8,109 | ) | ||||||||||
| Cumulative effect of change in accounting principle | — | (6,359 | ) | — | — | |||||||||||
| Net income (loss) | $ | 10,582 | $ | 5,160 | $ | (9,544 | ) | $ | (8,109 | ) | ||||||
| Basic and diluted earnings (loss) per share | $ | .06 | $ | .03 | $ | (.05 | ) | $ | (.04 | ) | ||||||
| Three months ended | Six months ended | |||||||||||||||
| October 31, 2002 | October 31, 2002 | |||||||||||||||
| As reported | Pro forma | As reported | Pro forma | |||||||||||||
| Revenues | $ | 471,396 | $ | 481,003 | $ | 902,762 | $ | 923,760 | ||||||||
| Loss before taxes | (62,245 | ) | (60,744 | ) | (78,151 | ) | (74,258 | ) | ||||||||
| Net loss | $ | (37,347 | ) | $ | (36,446 | ) | $ | (46,891 | ) | $ | (44,555 | ) | ||||
| Basic and diluted loss per share | $ | (.21 | ) | $ | (.20 | ) | $ | (.26 | ) | $ | (.25 | ) | ||||
Revenues recognized during the three months ended July 31, 2003 and October 31, 2003 and the six months ended October 31, 2003, which were initially recognized in prior periods and reversed as part of the cumulative effect of a change in accounting principle, totaled $10,847, $9,578 and $20,425, respectively.
Exposure Draft — Amendment of SFAS 140
The FASB has decided to reissue its exposure draft, “Qualifying Special Purpose Entities and Isolation of Transferred Assets, an Amendment of FASB Statement No. 140,” during the first quarter of calendar year 2004. The purpose of the proposal is to provide more specific guidance on the accounting for transfers of financial assets to a QSPE.
Provisions in the first exposure draft, if adopted, may have required the Company to consolidate its current QSPEs (the Trusts) established in its Mortgage Operations segment. As of October 31, 2003, the Trusts had assets and liabilities of $3,811,085. The provisions of the exposure draft are subject to FASB due process and are subject to change. The Company will continue to
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monitor the status of the exposure draft, and consider changes to current structures to comply with the proposed rules.
| 14. | Condensed Consolidating Financial Statements | |
| Three months ended January 31, 2003 | |||||||||||||||||||||
| H&R Block, Inc. | BFC | Other | Consolidated | ||||||||||||||||||
| (Guarantor) | (Issuer) | Subsidiaries | Elims | H&R Block | |||||||||||||||||
| Total revenues | $ | — | $ | 484,901 | $ | 473,597 | $ | (85 | ) | $ | 958,413 | ||||||||||
| Expenses: | |||||||||||||||||||||
| Compensation & benefits | — | 105,387 | 246,785 | 37 | 352,209 | ||||||||||||||||
| Occupancy & equipment | — | 19,780 | 67,569 | — | 87,349 | ||||||||||||||||
| Interest | — | 13,960 | 10,857 | — | 24,817 | ||||||||||||||||
| Depreciation & amortization | — | 20,490 | 22,180 | — | 42,670 | ||||||||||||||||
| Marketing & advertising | — | 9,999 | 45,486 | (154 | ) | 55,331 | |||||||||||||||
| Supplies, freight & postage | — | 8,167 | 24,987 | — | 33,154 | ||||||||||||||||
| Other | — | 76,035 | 66,626 | (70 | ) | 142,591 | |||||||||||||||
| — | 253,818 | 484,490 | (187 | ) | 738,121 | ||||||||||||||||
| Operating earnings (loss) | — | 231,083 | (10,893 | ) | 102 | 220,292 | |||||||||||||||
| Other income, net | 222,934 | — | 2,642 | (222,934 | ) | 2,642 | |||||||||||||||
| Earnings (loss) before income taxes (benefit) | 222,934 | 231,083 | (8,251 | ) | (222,832 | ) | 222,934 | ||||||||||||||
| Income taxes (benefit) | 90,621 | 93,931 | (3,354 | ) | (90,577 | ) | 90,621 | ||||||||||||||
| Net earnings (loss) | $ | 132,313 | $ | 137,152 | $ | (4,897 | ) | $ | (132,255 | ) | $ | 132,313 | |||||||||
-14-Block Financial Corporation (BFC) is an indirect, wholly owned consolidated subsidiary of the Company. BFC is the Issuer and the Company is the Guarantor of the Senior Notes issued on October 21, 1997 and April 13, 2000. These condensed consolidating financial statements have been prepared using the equity method of accounting. Earnings of subsidiaries are, therefore, reflected in the Company’s investment in subsidiaries account. The elimination entries eliminate investments in subsidiaries, related stockholder’s equity and other intercompany balances and transactions.
Condensed Consolidating Income Statements
| Three months ended October 31, 2003 | ||||||||||||||||||||||
| H&R Block, Inc. | BFC | Other | Consolidated | |||||||||||||||||||
| (Guarantor) | (Issuer) | Subsidiaries | Elims | H&R Block | ||||||||||||||||||
| Total revenues | $ | — | $ | 407,279 | $ | 172,638 | $ | (62 | ) | $ | 579,855 | |||||||||||
| Expenses: | ||||||||||||||||||||||
| Compensation & benefits | — | 114,390 | 141,352 | 22 | 255,764 | |||||||||||||||||
| Occupancy & equipment | — | 19,810 | 62,504 | — | 82,314 | |||||||||||||||||
| Interest | — | 11,612 | 8,288 | — | 19,900 | |||||||||||||||||
| Depreciation & amortization | — | 18,391 | 21,689 | — | 40,080 | |||||||||||||||||
| Marketing & advertising | — | 9,831 | 12,016 | (164 | ) | 21,683 | ||||||||||||||||
| Supplies, freight & postage | — | 3,684 | 10,503 | — | 14,187 | |||||||||||||||||
| Other | — | 90,981 | 39,060 | (84 | ) | 129,957 | ||||||||||||||||
| — | 268,699 | 295,412 | (226 | ) | 563,885 | |||||||||||||||||
| Operating income (loss) | — | 138,580 | (122,774 | ) | 164 | 15,970 | ||||||||||||||||
| Other income, net | 17,134 | — | 1,164 | (17,134 | ) | 1,164 | ||||||||||||||||
| Income (loss) before taxes (benefit) | 17,134 | 138,580 | (121,610 | ) | (16,970 | ) | 17,134 | |||||||||||||||
| Income taxes (benefit) | 6,758 | 56,410 | (49,716 | ) | (6,694 | ) | 6,758 | |||||||||||||||
| Net income (loss) | $ | 10,376 | $ | 82,170 | $ | (71,894 | ) | $ | (10,276 | ) | $ | 10,376 | ||||||||||
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| Three months ended January 31, 2002 | |||||||||||||||||||||
| H&R Block, Inc. | BFC | Other | Consolidated | ||||||||||||||||||
| (Guarantor) | (Issuer) | Subsidiaries | Elims | H&R Block | |||||||||||||||||
| Total revenues | $ | — | $ | 290,939 | $ | 444,884 | $ | (2,291 | ) | $ | 733,532 | ||||||||||
| Expenses: | |||||||||||||||||||||
| Compensation & benefits | — | 82,464 | 238,889 | — | 321,353 | ||||||||||||||||
| Occupancy & equipment | — | 14,711 | 57,967 | — | 72,678 | ||||||||||||||||
| Interest | — | 24,175 | 6,558 | — | 30,733 | ||||||||||||||||
| Depreciation & amortization | — | 17,667 | 20,500 | — | 38,167 | ||||||||||||||||
| Marketing & advertising | — | 6,441 | 45,564 | (100 | ) | 51,905 | |||||||||||||||
| Supplies, freight & postage | — | 3,402 | 18,606 | — | 22,008 | ||||||||||||||||
| Other | — | 86,245 | 63,788 | (2,291 | ) | 147,742 | |||||||||||||||
| — | 235,105 | 451,872 | (2,391 | ) | 684,586 | ||||||||||||||||
| Operating earnings (loss) | — | 55,834 | (6,988 | ) | 100 | 48,946 | |||||||||||||||
| Other income, net | 49,774 | — | 828 | (49,774 | ) | 828 | |||||||||||||||
| Earnings (loss) before income taxes (benefit) | 49,774 | 55,834 | (6,160 | ) | (49,674 | ) | 49,774 | ||||||||||||||
| Income taxes (benefit) | 20,158 | 22,675 | (2,557 | ) | (20,118 | ) | 20,158 | ||||||||||||||
| Net earnings (loss) | $ | 29,616 | $ | 33,159 | $ | (3,603 | ) | $ | (29,556 | ) | $ | 29,616 | |||||||||
| Nine months ended January 31, 2003 | |||||||||||||||||||||
| H&R Block, Inc. | BFC | Other | Consolidated | ||||||||||||||||||
| (Guarantor) | (Issuer) | Subsidiaries | Elims | H&R Block | |||||||||||||||||
| Total revenues | $ | — | $ | 1,121,858 | $ | 739,547 | $ | (230 | ) | $ | 1,861,175 | ||||||||||
| Expenses: | |||||||||||||||||||||
| Compensation & benefits | — | 294,779 | 496,553 | 360 | 791,692 | ||||||||||||||||
| Occupancy & equipment | — | 51,199 | 172,443 | — | 223,642 | ||||||||||||||||
| Interest | — | 47,690 | 22,099 | — | 69,789 | ||||||||||||||||
| Depreciation & amortization | — | 58,027 | 56,711 | — | 114,738 | ||||||||||||||||
| Marketing & advertising | — | 22,561 | 63,237 | (463 | ) | 85,335 | |||||||||||||||
| Supplies, freight & postage | — | 16,724 | 38,748 | — | 55,472 | ||||||||||||||||
| Impairment of goodwill | — | 24,000 | — | — | 24,000 | ||||||||||||||||
| Texas litigation reserve | — | — | 41,672 | — | 41,672 | ||||||||||||||||
| Other | — | 185,195 | 129,971 | (538 | ) | 314,628 | |||||||||||||||
| — | 700,175 | 1,021,434 | (641 | ) | 1,720,968 | ||||||||||||||||
| Operating earnings (loss) | — | 421,683 | (281,887 | ) | 411 | 140,207 | |||||||||||||||
| Other income, net | 144,783 | — | 4,576 | (144,783 | ) | 4,576 | |||||||||||||||
| Earnings (loss) before income taxes (benefit) | 144,783 | 421,683 | (277,311 | ) | (144,372 | ) | 144,783 | ||||||||||||||
| Income taxes (benefit) | 59,361 | 180,671 | (121,478 | ) | (59,193 | ) | 59,361 | ||||||||||||||
| Net earnings (loss) | $ | 85,422 | $ | 241,012 | $ | (155,833 | ) | $ | (85,179 | ) | $ | 85,422 | |||||||||
| Three months ended October 31, 2002 | |||||||||||||||||||||
| H&R Block, Inc. | BFC | Other | Consolidated | ||||||||||||||||||
| (Guarantor) | (Issuer) | Subsidiaries | Elims | H&R Block | |||||||||||||||||
| Total revenues | $ | — | $ | 326,054 | $ | 145,384 | $ | (42 | ) | $ | 471,396 | ||||||||||
| Expenses: | |||||||||||||||||||||
| Compensation & benefits | — | 98,007 | 131,197 | 91 | 229,295 | ||||||||||||||||
| Occupancy & equipment | — | 17,256 | 54,175 | — | 71,431 | ||||||||||||||||
| Interest | — | 16,004 | 6,694 | — | 22,698 | ||||||||||||||||
| Depreciation & amortization- | 19,066 | 17,429 | — | 36,495 | |||||||||||||||||
| Marketing & advertising | — | 8,039 | 12,934 | (155 | ) | 20,818 | |||||||||||||||
| Supplies, freight & postage | — | 4,660 | 9,192 | — | 13,852 | ||||||||||||||||
| Impairment of goodwill | — | 6,000 | — | — | 6,000 | ||||||||||||||||
| Other | — | 55,437 | 78,190 | (132 | ) | 133,495 | |||||||||||||||
| — | 224,469 | 309,811 | (196 | ) | 534,084 | ||||||||||||||||
| Operating income (loss) | — | 101,585 | (164,427 | ) | 154 | (62,688 | ) | ||||||||||||||
| Other income, net | (62,245 | ) | — | 443 | 62,245 | 443 | |||||||||||||||
| Income (loss) before taxes (benefit) | (62,245 | ) | 101,585 | (163,984 | ) | 62,399 | (62,245 | ) | |||||||||||||
| Income taxes (benefit) | (24,898 | ) | 32,099 | (57,060 | ) | 24,961 | (24,898 | ) | |||||||||||||
| Net income (loss) | $ | (37,347 | ) | $ | 69,486 | $ | (106,924 | ) | $ | 37,438 | $ | (37,347 | ) | ||||||||
| Six months ended October 31, 2003 | ||||||||||||||||||||||
| H&R Block, Inc. | BFC | Other | Consolidated | |||||||||||||||||||
| (Guarantor) | (Issuer) | Subsidiaries | Elims | H&R Block | ||||||||||||||||||
| Total revenues | $ | — | $ | 772,610 | $ | 313,039 | $ | (104 | ) | $ | 1,085,545 | |||||||||||
| Expenses: | ||||||||||||||||||||||
| Compensation & benefits | — | 218,079 | 262,824 | 66 | 480,969 | |||||||||||||||||
| Occupancy & equipment | — | 38,797 | 119,668 | — | 158,465 | |||||||||||||||||
| Interest | — | 24,463 | 18,633 | — | 43,096 | |||||||||||||||||
| Depreciation & amortization | — | 36,092 | 39,918 | — | 76,010 | |||||||||||||||||
| Marketing & advertising | — | 16,441 | 15,679 | (329 | ) | 31,791 | ||||||||||||||||
| Supplies, freight & postage | — | 8,101 | 14,640 | — | 22,741 | |||||||||||||||||
| Other | — | 161,885 | 77,654 | (170 | ) | 239,369 | ||||||||||||||||
| — | 503,858 | 549,016 | (433 | ) | 1,052,441 | |||||||||||||||||
| Operating income (loss) | — | 268,752 | (235,977 | ) | 329 | 33,104 | ||||||||||||||||
| Other income, net | 35,963 | — | 2,859 | (35,963 | ) | 2,859 | ||||||||||||||||
| Income (loss) before taxes (benefit) | 35,963 | 268,752 | (233,118 | ) | (35,634 | ) | 35,963 | |||||||||||||||
| Income taxes (benefit) | 14,068 | 109,551 | (95,612 | ) | (13,939 | ) | 14,068 | |||||||||||||||
| Net income (loss) before change in accounting | 21,895 | 159,201 | (137,506 | ) | (21,695 | ) | 21,895 | |||||||||||||||
| Cumulative effect of change in accounting | (6,359 | ) | — | (6,359 | ) | 6,359 | (6,359 | ) | ||||||||||||||
| Net income (loss) | $ | 15,536 | $ | 159,201 | $ | (143,865 | ) | $ | (15,336 | ) | $ | 15,536 | ||||||||||
-15--23-
| Nine months ended January 31, 2002 | |||||||||||||||||||||
| H&R Block, Inc. | BFC | Other | Consolidated | ||||||||||||||||||
| (Guarantor) | (Issuer) | Subsidiaries | Elims | H&R Block | |||||||||||||||||
| Total revenues | $ | — | $ | 757,341 | $ | 681,412 | $ | (2,344 | ) | $ | 1,436,409 | ||||||||||
| Expenses: | |||||||||||||||||||||
| Compensation & benefits | — | 237,621 | 460,448 | — | 698,069 | ||||||||||||||||
| Occupancy & equipment | — | 45,611 | 148,495 | — | 194,106 | ||||||||||||||||
| Interest | — | 78,920 | 11,403 | — | 90,323 | ||||||||||||||||
| Depreciation & amortization | — | 51,316 | 55,779 | — | 107,095 | ||||||||||||||||
| Marketing & advertising | — | 14,293 | 60,975 | (302 | ) | 74,966 | |||||||||||||||
| Supplies, freight & postage | — | 10,630 | 27,421 | — | 38,051 | ||||||||||||||||
| Other | — | 172,193 | 116,184 | (2,344 | ) | 286,033 | |||||||||||||||
| — | 610,584 | 880,705 | (2,646 | ) | 1,488,643 | ||||||||||||||||
| Operating earnings (loss) | — | 146,757 | (199,293 | ) | 302 | (52,234 | ) | ||||||||||||||
| Other income, net | (49,041 | ) | — | 3,193 | 49,041 | 3,193 | |||||||||||||||
| Earnings (loss) before income taxes (benefit) | (49,041 | ) | 146,757 | (196,100 | ) | 49,343 | (49,041 | ) | |||||||||||||
| Income taxes (benefit) | (19,862 | ) | 60,212 | (80,196 | ) | 19,984 | (19,862 | ) | |||||||||||||
| Net earnings (loss) | $ | (29,179 | ) | $ | 86,545 | $ | (115,904 | ) | $ | 29,359 | $ | (29,179 | ) | ||||||||
| Six months ended October 31, 2002 | ||||||||||||||||||||||
| H&R Block, Inc. | BFC | Other | Consolidated | |||||||||||||||||||
| (Guarantor) | (Issuer) | Subsidiaries | Elims | H&R Block | ||||||||||||||||||
| Total revenues | $ | — | $ | 636,957 | $ | 265,950 | $ | (145 | ) | $ | 902,762 | |||||||||||
| Expenses: | ||||||||||||||||||||||
| Compensation & benefits | — | 189,392 | 249,768 | 323 | 439,483 | |||||||||||||||||
| Occupancy & equipment | — | 31,419 | 104,874 | — | 136,293 | |||||||||||||||||
| Interest | — | 33,730 | 11,242 | — | 44,972 | |||||||||||||||||
| Depreciation & amortization | — | 37,537 | 34,531 | — | 72,068 | |||||||||||||||||
| Marketing & advertising | — | 12,562 | 17,751 | (309 | ) | 30,004 | ||||||||||||||||
| Supplies, freight & postage | — | 8,557 | 13,761 | — | 22,318 | |||||||||||||||||
| Goodwill impairment | — | 24,000 | — | — | 24,000 | |||||||||||||||||
| Other | — | 109,160 | 105,017 | (468 | ) | 213,709 | ||||||||||||||||
| — | 446,357 | 536,944 | (454 | ) | 982,847 | |||||||||||||||||
| Operating income (loss) | — | 190,600 | (270,994 | ) | 309 | (80,085 | ) | |||||||||||||||
| Other income, net | (78,151 | ) | — | 1,934 | 78,151 | 1,934 | ||||||||||||||||
| Income (loss) before taxes (benefit) | (78,151 | ) | 190,600 | (269,060 | ) | 78,460 | (78,151 | ) | ||||||||||||||
| Income taxes (benefit) | (31,260 | ) | 76,364 | (107,748 | ) | 31,384 | (31,260 | ) | ||||||||||||||
| Net income (loss) | $ | (46,891 | ) | $ | 114,236 | $ | (161,312 | ) | $ | 47,076 | $ | (46,891 | ) | |||||||||
Condensed Consolidating Balance Sheets
| January 31, 2003 | |||||||||||||||||||||
| H&R Block, Inc. | BFC | Other | Consolidated | ||||||||||||||||||
| (Guarantor) | (Issuer) | Subsidiaries | Elims | H&R Block | |||||||||||||||||
| Cash & cash equivalents | $ | — | $ | 175,985 | $ | 260,933 | $ | — | $ | 436,918 | |||||||||||
| Cash & equivalents-restricted | — | 405,733 | 12,988 | — | 418,721 | ||||||||||||||||
| Receivables from customers, brokers and dealers | — | 546,251 | — | — | 546,251 | ||||||||||||||||
| Receivables | 699 | 174,367 | 290,129 | — | 465,195 | ||||||||||||||||
| Intangible assets and goodwill | — | 498,416 | 578,109 | — | 1,076,525 | ||||||||||||||||
| Investments in subsidiaries | 3,037,949 | 205 | 1,263 | (3,037,949 | ) | 1,468 | |||||||||||||||
| Other assets | — | 1,082,987 | 220,206 | 965 | 1,304,158 | ||||||||||||||||
| Total assets | $ | 3,038,648 | $ | 2,883,944 | $ | 1,363,628 | $ | (3,036,984 | ) | $ | 4,249,236 | ||||||||||
| Notes payable | $ | — | $ | 586,803 | $ | — | $ | — | $ | 586,803 | |||||||||||
| Accts. payable to customers, brokers and dealers | — | 823,890 | — | — | 823,890 | ||||||||||||||||
| Long-term debt | — | 747,387 | 134,882 | — | 882,269 | ||||||||||||||||
| Other liabilities | 1,143 | 423,408 | 364,941 | (708 | ) | 788,784 | |||||||||||||||
| Net intercompany advances | 1,870,015 | (438,782 | ) | (1,432,494 | ) | 1,261 | — | ||||||||||||||
| Stockholders’ equity | 1,167,490 | 741,238 | 2,296,299 | (3,037,537 | ) | 1,167,490 | |||||||||||||||
| Total liabilities and stockholders’ equity | $ | 3,038,648 | $ | 2,883,944 | $ | 1,363,628 | $ | (3,036,984 | ) | $ | 4,249,236 | ||||||||||
-16-
| October 31, 2003 | |||||||||||||||||||||
| H&R Block, Inc. | BFC | Other | Consolidated | ||||||||||||||||||
| (Guarantor) | (Issuer) | Subsidiaries | Elims | H&R Block | |||||||||||||||||
| Cash & cash equivalents | $ | — | $ | 158,659 | $ | 102,671 | $ | — | $ | 261,330 | |||||||||||
| Cash & cash equivalents - - restricted | — | 559,715 | 11,448 | — | 571,163 | ||||||||||||||||
| Receivables from customers, brokers and dealers, net | — | 584,721 | — | — | 584,721 | ||||||||||||||||
| Receivables, net | 2,393 | 173,556 | 164,845 | — | 340,794 | ||||||||||||||||
| Intangible assets and goodwill, net | — | 476,441 | 703,800 | — | 1,180,241 | ||||||||||||||||
| Investments in subsidiaries | 3,593,778 | 215 | 797 | (3,593,778 | ) | 1,012 | |||||||||||||||
| Other assets | (240 | ) | 1,156,433 | 365,205 | 717 | 1,522,115 | |||||||||||||||
| Total assets | $ | 3,595,931 | $ | 3,109,740 | $ | 1,348,766 | $ | (3,593,061 | ) | $ | 4,461,376 | ||||||||||
| Notes payable | $ | — | $ | 124,630 | $ | — | $ | — | $ | 124,630 | |||||||||||
| Accts. payable to customers, brokers and dealers | — | 999,009 | — | — | 999,009 | ||||||||||||||||
| Long-term debt | — | 747,875 | 59,863 | — | 807,738 | ||||||||||||||||
| Other liabilities | 2 | 413,318 | 580,782 | — | 994,102 | ||||||||||||||||
| Net intercompany advances | 2,060,032 | (215,954 | ) | (1,844,465 | ) | 387 | — | ||||||||||||||
| Stockholders’ equity | 1,535,897 | 1,040,862 | 2,552,586 | (3,593,448 | ) | 1,535,897 | |||||||||||||||
| Total liabilities and stockholders’ equity | $ | 3,595,931 | $ | 3,109,740 | $ | 1,348,766 | $ | (3,593,061 | ) | $ | 4,461,376 | ||||||||||
-24-
| April 30, 2002 | |||||||||||||||||||||
| H&R Block, Inc. | BFC | Other | Consolidated | ||||||||||||||||||
| (Guarantor) | (Issuer) | Subsidiaries | Elims | H&R Block | |||||||||||||||||
| Cash & cash equivalents | $ | — | $ | 197,959 | $ | 238,186 | $ | — | $ | 436,145 | |||||||||||
| Cash & equivalents-restricted | — | 140,180 | 11,993 | — | 152,173 | ||||||||||||||||
| Receivables from customers, brokers and dealers | — | 844,538 | — | — | 844,538 | ||||||||||||||||
| Receivables | 151 | 157,747 | 210,447 | — | 368,345 | ||||||||||||||||
| Intangible assets and goodwill | — | 544,391 | 562,550 | — | 1,106,941 | ||||||||||||||||
| Investments in subsidiaries | 2,973,936 | 215 | 1,609 | (2,973,936 | ) | 1,824 | |||||||||||||||
| Other assets | — | 1,006,531 | 314,381 | (87 | ) | 1,320,825 | |||||||||||||||
| Total assets | $ | 2,974,087 | $ | 2,891,561 | $ | 1,339,166 | $ | (2,974,023 | ) | $ | 4,230,791 | ||||||||||
| Accts. payable to customers, brokers and dealers | $ | — | $ | 903,201 | $ | — | $ | — | $ | 903,201 | |||||||||||
| Long-term debt | — | 746,900 | 121,487 | — | 868,387 | ||||||||||||||||
| Other liabilities | 6,032 | 335,687 | 748,347 | (283 | ) | 1,089,783 | |||||||||||||||
| Net intercompany advances | 1,598,635 | 373,975 | (1,972,935 | ) | 325 | — | |||||||||||||||
| Stockholders’ equity | 1,369,420 | 531,798 | 2,442,267 | (2,974,065 | ) | 1,369,420 | |||||||||||||||
| Total liabilities and stockholders’ equity | $ | 2,974,087 | $ | 2,891,561 | $ | 1,339,166 | $ | (2,974,023 | ) | $ | 4,230,791 | ||||||||||
| April 30, 2003 | |||||||||||||||||||||
| H&R Block, Inc. | BFC | Other | Consolidated | ||||||||||||||||||
| (Guarantor) | (Issuer) | Subsidiaries | Elims | H&R Block | |||||||||||||||||
| Cash & cash equivalents | $ | — | $ | 180,181 | $ | 695,172 | $ | — | $ | 875,353 | |||||||||||
| Cash & cash equivalents - - restricted | — | 420,787 | 17,455 | — | 438,242 | ||||||||||||||||
| Receivables from customers, brokers and dealers, net | — | 517,037 | — | — | 517,037 | ||||||||||||||||
| Receivables, net | 168 | 171,612 | 231,417 | — | 403,197 | ||||||||||||||||
| Intangible assets and goodwill, net | — | 491,091 | 564,989 | — | 1,056,080 | ||||||||||||||||
| Investments in subsidiaries | 3,546,734 | 215 | 1,105 | (3,546,734 | ) | 1,320 | |||||||||||||||
| Other assets | (1,321 | ) | 1,019,118 | 293,930 | 949 | 1,312,676 | |||||||||||||||
| Total assets | $ | 3,545,581 | $ | 2,800,041 | $ | 1,804,068 | $ | (3,545,785 | ) | $ | 4,603,905 | ||||||||||
| Accts. payable to customers, brokers and dealers | $ | — | $ | 862,694 | $ | — | $ | — | $ | 862,694 | |||||||||||
| Long-term debt | — | 747,550 | 74,752 | — | 822,302 | ||||||||||||||||
| Other liabilities | 2,654 | 360,125 | 892,457 | (36 | ) | 1,255,200 | |||||||||||||||
| Net intercompany advances | 1,879,218 | (37,776 | ) | (1,841,943 | ) | 501 | — | ||||||||||||||
| Stockholders’ equity | 1,663,709 | 867,448 | 2,678,802 | (3,546,250 | ) | 1,663,709 | |||||||||||||||
| Total liabilities and stockholders’ equity | $ | 3,545,581 | $ | 2,800,041 | $ | 1,804,068 | $ | (3,545,785 | ) | $ | 4,603,905 | ||||||||||
-17--25-
Condensed Consolidating Statements of Cash Flows
| Nine months ended January 31, 2003 | ||||||||||||||||||||||
| H&R Block, Inc. | BFC | Other | Consolidated | |||||||||||||||||||
| (Guarantor) | (Issuer) | Subsidiaries | Elims | H&R Block | ||||||||||||||||||
| Net cash provided by (used in) operating activities: | $ | 27,060 | $ | (21,514 | ) | $ | (372,295 | ) | $ | — | $ | (366,749 | ) | |||||||||
| Cash flows from investing: | ||||||||||||||||||||||
| Purchase of AFS securities | — | (10,577 | ) | — | — | (10,577 | ) | |||||||||||||||
| Cash received on residuals | — | 117,522 | — | — | 117,522 | |||||||||||||||||
| Proceeds from sale of residuals previously securitized | — | 142,486 | — | — | 142,486 | |||||||||||||||||
| Maturities of AFS securities | — | 7,730 | 2,000 | — | 9,730 | |||||||||||||||||
| Purchase property & equipment | — | (30,149 | ) | (65,480 | ) | — | (95,629 | ) | ||||||||||||||
| Payments for business acq | — | — | (24,239 | ) | — | (24,239 | ) | |||||||||||||||
| Net intercompany advances | 271,380 | (812,757 | ) | 541,377 | — | — | ||||||||||||||||
| Other, net | — | (1,518 | ) | (4,486 | ) | — | (6,004 | ) | ||||||||||||||
| Net cash provided by (used in) investing activities | 271,380 | (587,263 | ) | 449,172 | — | 133,289 | ||||||||||||||||
| Cash flows from financing: | ||||||||||||||||||||||
| Repayments of notes payable | — | (9,301,285 | ) | — | — | (9,301,285 | ) | |||||||||||||||
| Proceeds from notes payable | — | 9,888,088 | — | — | 9,888,088 | |||||||||||||||||
| Payments on acquisition debt | — | — | (52,107 | ) | — | (52,107 | ) | |||||||||||||||
| Dividends paid | (93,645 | ) | — | — | — | (93,645 | ) | |||||||||||||||
| Payments to acquire treasury shares | (317,608 | ) | — | — | — | (317,608 | ) | |||||||||||||||
| Proceeds from issuance of common stock | 112,813 | — | — | — | 112,813 | |||||||||||||||||
| Other, net | — | — | (2,023 | ) | — | (2,023 | ) | |||||||||||||||
| Net cash provided by (used in) financing activities | (298,440 | ) | 586,803 | (54,130 | ) | — | 234,233 | |||||||||||||||
| Net increase (decrease) in cash | — | (21,974 | ) | 22,747 | — | 773 | ||||||||||||||||
| Cash — beginning of period | — | 197,959 | 238,186 | — | 436,145 | |||||||||||||||||
| Cash — end of period | $ | — | $ | 175,985 | $ | 260,933 | $ | — | $ | 436,918 | ||||||||||||
| Six months ended October 31, 2003 | ||||||||||||||||||||||
| H&R Block, Inc. | BFC | Other | Consolidated | |||||||||||||||||||
| (Guarantor) | (Issuer) | Subsidiaries | Elims | H&R Block | ||||||||||||||||||
| Net cash provided by (used in) operating activities: | $ | 6,269 | $ | (93,412 | ) | $ | (376,207 | ) | $ | — | $ | (463,350 | ) | |||||||||
| Cash flows from investing: | ||||||||||||||||||||||
| Purchase of AFS securities | — | — | (9,557 | ) | — | (9,557 | ) | |||||||||||||||
| Cash received on residuals | — | 68,850 | — | — | 68,850 | |||||||||||||||||
| Sales of AFS securities | — | 10,827 | 2,894 | — | 13,721 | |||||||||||||||||
| Purchase property & equipment | — | (10,212 | ) | (33,379 | ) | — | (43,591 | ) | ||||||||||||||
| Payments for business acq | — | — | (123,337 | ) | — | (123,337 | ) | |||||||||||||||
| Net intercompany advances | 180,814 | — | — | (180,814 | ) | — | ||||||||||||||||
| Other, net | — | 5,873 | (3,346 | ) | — | 2,527 | ||||||||||||||||
| Net cash provided by (used in) investing activities | 180,814 | 75,338 | (166,725 | ) | (180,814 | ) | (91,387 | ) | ||||||||||||||
| Cash flows from financing: | ||||||||||||||||||||||
| Repayments of notes payable | — | (499,771 | ) | — | — | (499,771 | ) | |||||||||||||||
| Proceeds from notes payable | — | 624,401 | — | — | 624,401 | |||||||||||||||||
| Proceeds from securitization financing | — | 50,100 | — | — | 50,100 | |||||||||||||||||
| Payments on acquisition debt | — | — | (45,100 | ) | — | (45,100 | ) | |||||||||||||||
| Dividends paid | (68,087 | ) | — | — | — | (68,087 | ) | |||||||||||||||
| Acquisition of treasury shares | (178,847 | ) | — | — | — | (178,847 | ) | |||||||||||||||
| Proceeds from issuance of common stock | 59,851 | — | — | — | 59,851 | |||||||||||||||||
| Net intercompany advances | — | (178,178 | ) | (2,636 | ) | 180,814 | — | |||||||||||||||
| Other, net | — | — | (1,833 | ) | — | (1,833 | ) | |||||||||||||||
| Net cash provided by (used in) financing activities | (187,083 | ) | (3,448 | ) | (49,569 | ) | 180,814 | (59,286 | ) | |||||||||||||
| Net decrease in cash | — | (21,522 | ) | (592,501 | ) | — | (614,023 | ) | ||||||||||||||
| Cash — beginning of period | — | 180,181 | 695,172 | — | 875,353 | |||||||||||||||||
| Cash — end of period | $ | — | $ | 158,659 | $ | 102,671 | $ | — | $ | 261,330 | ||||||||||||
-18--26-
| Nine months ended January 31, 2002 | |||||||||||||||||||||
| H&R Block, Inc. | BFC | Other | Consolidated | ||||||||||||||||||
| (Guarantor) | (Issuer) | Subsidiaries | Elims | H&R Block | |||||||||||||||||
| Net cash provided by (used in) operating activities | $ | 53,842 | $ | (491,974 | ) | $ | (482,716 | ) | $ | — | $ | (920,848 | ) | ||||||||
| Cash flows from investing: | |||||||||||||||||||||
| Purchase of AFS securities | — | — | (3,695 | ) | — | (3,695 | ) | ||||||||||||||
| Cash received on residuals | — | 33,006 | — | — | 33,006 | ||||||||||||||||
| Maturities of AFS securities | — | — | 28,203 | — | 28,203 | ||||||||||||||||
| Purchase property & equipment | — | (27,954 | ) | (43,389 | ) | — | (71,343 | ) | |||||||||||||
| Payments for business acq | — | — | (44,397 | ) | — | (44,397 | ) | ||||||||||||||
| Net intercompany advances | 197,895 | (803,705 | ) | 605,810 | — | — | |||||||||||||||
| Other, net | — | — | (8,538 | ) | — | (8,538 | ) | ||||||||||||||
| Net cash provided by (used in) investing activities | 197,895 | (798,653 | ) | 533,994 | — | (66,764 | ) | ||||||||||||||
| Cash flows from financing: | |||||||||||||||||||||
| Repayments of notes payable | — | (6,147,398 | ) | — | — | (6,147,398 | ) | ||||||||||||||
| Proceeds from notes payable | — | 7,786,230 | — | — | 7,786,230 | ||||||||||||||||
| Payments on acquisition debt | — | — | (49,479 | ) | — | (49,479 | ) | ||||||||||||||
| Dividends paid | (86,349 | ) | — | — | — | (86,349 | ) | ||||||||||||||
| Payments to acquire treasury shares | (352,213 | ) | — | — | — | (352,213 | ) | ||||||||||||||
| Proceeds from issuance of common stock | 186,825 | — | — | — | 186,825 | ||||||||||||||||
| Other, net | — | — | 688 | — | 688 | ||||||||||||||||
| Net cash provided by (used in) financing activities | (251,737 | ) | 1,638,832 | (48,791 | ) | — | 1,338,304 | ||||||||||||||
| Net increase in cash | — | 348,205 | 2,487 | — | 350,692 | ||||||||||||||||
| Cash — beginning of period | — | 82,942 | 104,674 | — | 187,616 | ||||||||||||||||
| Cash — end of period | $ | — | $ | 431,147 | $ | 107,161 | $ | — | $ | 538,308 | |||||||||||
| Six months ended October 31, 2002 | ||||||||||||||||||||||
| H&R Block, Inc. | BFC | Other | Consolidated | |||||||||||||||||||
| (Guarantor) | (Issuer) | Subsidiaries | Elims | H&R Block | ||||||||||||||||||
| Net cash provided by (used in) operating activities | $ | 19,163 | $ | (1,181 | ) | $ | (367,810 | ) | $ | — | $ | (349,828 | ) | |||||||||
| Cash flows from investing: | ||||||||||||||||||||||
| Purchase of AFS securities | — | — | (7,692 | ) | — | (7,692 | ) | |||||||||||||||
| Cash received on residuals | — | 103,885 | — | — | 103,885 | |||||||||||||||||
| Sales of AFS securities | — | — | 7,946 | — | 7,946 | |||||||||||||||||
| Purchase property & equipment | — | (7,486 | ) | (49,517 | ) | — | (57,003 | ) | ||||||||||||||
| Payments for business acq | — | — | (21,397 | ) | — | (21,397 | ) | |||||||||||||||
| Net intercompany advances | 261,247 | — | — | (261,247 | ) | — | ||||||||||||||||
| Other, net | — | (556 | ) | (2,257 | ) | — | (2,813 | ) | ||||||||||||||
| Net cash provided by (used in) investing activities | 261,247 | 95,843 | (72,917 | ) | (261,247 | ) | 22,926 | |||||||||||||||
| Cash flows from financing: | ||||||||||||||||||||||
| Repayments of notes payable | — | (6,430,067 | ) | — | — | (6,430,067 | ) | |||||||||||||||
| Proceeds from notes payable | — | 6,911,680 | — | — | 6,911,680 | |||||||||||||||||
| Payments on acquisition debt | — | — | (47,995 | ) | — | (47,995 | ) | |||||||||||||||
| Dividends paid | (61,474 | ) | — | — | — | (61,474 | ) | |||||||||||||||
| Acquisition of treasury shares | (313,603 | ) | — | — | — | (313,603 | ) | |||||||||||||||
| Proceeds from issuance of common stock | 94,667 | — | — | — | 94,667 | |||||||||||||||||
| Net intercompany advances | — | (670,362 | ) | 409,115 | 261,247 | — | ||||||||||||||||
| Other, net | — | — | (1,536 | ) | — | (1,536 | ) | |||||||||||||||
| Net cash provided by (used in) financing activities | (280,410 | ) | (188,749 | ) | 359,584 | 261,247 | 151,672 | |||||||||||||||
| Net decrease in cash | — | (94,087 | ) | (81,143 | ) | — | (175,230 | ) | ||||||||||||||
| Cash — beginning of period | — | 197,959 | 238,186 | — | 436,145 | |||||||||||||||||
| Cash — end of period | $ | — | $ | 103,872 | $ | 157,043 | $ | — | $ | 260,915 | ||||||||||||
| Subsequent Event | ||
-19-On November 25, 2003, the Company declared a cash dividend of $.20 per share to shareholders of record as of December 12, 2003, payable on January 2, 2004.
-27-
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
RESULTS OF OPERATIONS AND FINANCIAL CONDITION
H&R Block, Inc. (the Company) is a diversified company with subsidiaries that deliverprimarily engaged in the business of providing financial services including tax services, investment and mortgage products and services, and business, accounting and consulting services. For nearly 50 years, the Company has been developing relationships with millions of tax clients and its strategy is to expand on these relationships.
H&R Block’s Mission:
To help our clients achieve their financial objectives
by serving as their tax and financial partner.
H&R Block’s Vision:
To be the world’s leading provider of financial services
through tax and accounting basedaccounting-based advisory relationships.
Overview of Reportable Operating Segments
The principal business activity ofKey to achieving the Company’s operating subsidiariesmission and vision is providing taxenhancing client experiences through consistent delivery of valuable services and otheradvice. The Company believes offering advice facilitates a financial partnership and increases client satisfaction and retention. New products and services are continually introduced to bring additional value to the general public.overall experience and allow clients to reach their financial objectives. Operating in multiple lines of business allows the Company to serve the changing financial needs of all its customers. The Company does business incarries out its mission and vision through the following reportable operating segments:
| U.S. Tax Operations:This segment primarily consists of the Company’s income tax preparation businesses. Retail tax offices served 16.5 million taxpayers in fiscal year 2003 — more than any other personal tax services company. This segment also served 2.1 million clients through TaxCut tax preparation software (includes only federal e-filings) and online tax preparation in fiscal year 2003. By offering professional and do-it-yourself tax preparation options, the Company can serve its clients how they choose to be served. | ||
RESULTS OF OPERATIONSMortgage Operations:This segment is primarily engaged in the origination of non-prime mortgage loans, the sale and securitization of mortgage assets (which includes mortgage loans and residual interests), and the servicing of non-prime loans. A key focus of Mortgage Operations is to optimize cash flows from its operations. The Company believes offering mortgage products to other segments’ clients results in added value to the total client experience.
Business Services:This segment is engaged in providing accounting, tax, consulting, payroll, employee benefits and capital markets services to business clients and tax, financial and estate planning, wealth management and insurance services to individuals. The Company continues to focus on establishing core service relationships with middle-market clients by adding non-traditional business and personal services to enhance these client relationships. In doing so, the
-28-
Company intends to develop Business Services as a leading provider of middle-market professional services.
Investment Services:This segment is primarily engaged in offering investment services and securities products. Investment Services also offers these services and products to U.S. Tax and Mortgage Operations clients, bringing additional value to the overall client experience.
International Tax Operations:This segment is primarily engaged in providing local tax return preparation, filing and related services in Canada, Australia and the United Kingdom. In addition, International Tax Operations includes Overseas operations, which consists of company-owned and franchise offices preparing tax returns for U.S. citizens living abroad.
The analysis that follows should be read in conjunction with the tables below and the Consolidated Statements of Operationscondensed consolidated income statements found on page 2. All amounts in the following tables are in thousands, except as noted.
-20-
GAAP and Non-GAAP Financial Measures
GAAP refers to accounting principles generally accepted in the United States of America. Throughout this Management’s Discussion and Analysis of Results of Operations and Financial Condition, management discusses financial measures in accordance with GAAP and also on a non-GAAP basis. Non-GAAP financial measures presented herein include cash earnings and free cash flow. Further discussion of non-GAAP financial measures, including reconcilations of GAAP to non-GAAP financial measures, is included on pages 58 and 59.
General
During the third quarter, the Company completed the sale of $206.6 million of residual interests from prior securitizations. The transaction, which closed on November 15, 2002, resulted in a pretax gain of $130.9 million, or $.43 per diluted share. This gain is reflected as a separate line item in the Consolidated Statements of Operations, and in the Mortgage Operations segment, where applicable.
Also during the third quarter, the Company entered into an agreement with Household Tax Masters Inc. (Household), the servicer of refund anticipation loans (RALs), whereby the Company waived its right to purchase any participation interests in and receive license fees for RALs during the period January 1 through April 30, 2003. In consideration for waiving such rights, the Company will receive, during such period, a series of payments from Household totaling $133.0 million, subject to certain adjustments based on delinquency rates. As a result, RAL participation and related revenues for the third quarter declined approximately $6.0 million compared to the prior year.
Consolidated H&R Block, Inc.
Consolidated H&R Block, Inc. — Three-Month Results
| Three months ended | ||||||||||||
| January 31, | January 31, | October 31, | ||||||||||
| 2003 | 2002 | 2002 | ||||||||||
| Revenues | $ | 958,413 | $ | 733,532 | $ | 471,396 | ||||||
| Pretax earnings (loss) | 222,934 | 49,774 | (62,245 | ) | ||||||||
| Net earnings (loss) | $ | 132,313 | $ | 29,616 | $ | (37,347 | ) | |||||
| Basic earnings (loss) per share | $ | .74 | $ | .16 | $ | (.21 | ) | |||||
| Diluted earnings (loss) per share | $ | .73 | $ | .16 | $ | (.21 | ) | |||||
| Three months ended | |||||||||||||
| October 31, 2003 | October 31, 2002 | July 31, 2003 | |||||||||||
| Revenues | $ | 579,855 | $ | 471,396 | $ | 505,690 | |||||||
| Pretax income (loss) | 17,134 | (62,245 | ) | 18,829 | |||||||||
| Net income (loss) before change in accounting principle | 10,376 | (37,347 | ) | 11,519 | |||||||||
| Cumulative effect of change in accounting principle | — | — | (6,359 | ) | |||||||||
| Net income (loss) | $ | 10,376 | $ | (37,347 | ) | $ | 5,160 | ||||||
| Basic earnings (loss) per share: | |||||||||||||
| Before change in accounting principle | $ | .06 | $ | (.21 | ) | $ | .06 | ||||||
| Net income (loss) | $ | .06 | $ | (.21 | ) | $ | .03 | ||||||
| Diluted earnings (loss) per share: | |||||||||||||
| Before change in accounting principle | $ | .06 | $ | (.21 | ) | $ | .06 | ||||||
| Net income (loss) | $ | .06 | $ | (.21 | ) | $ | .03 | ||||||
Three months
Results for the quarter ended JanuaryJuly 31, 2003 compared to January 31, 2002have been restated for the adoption of Emerging Issues Task Force Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” (EITF 00-21).
Overview
Consolidated revenuesA summary of the Company’s results for the three months ended JanuaryOctober 31, 2003 were $958.4is as follows:
-29-
-21-
The Company reported pretax earnings of $222.9 million for the third quarter of fiscal year 2003 compared to $49.8 million in the prior year, an increase of $173.2 million. Mortgage Operations reported earnings of $262.5 million for the three months ended January 31, 2003, $185.0 million better than 2002,EITF 00-21, while expenses decreased 4.1%, primarily as a result of a litigation reserve recorded in the $130.9 million gain recorded on the sale of residual interests previously securitized, coupled withprior year.
The effective income tax rate forrespectively, over the three months ended January 31, 2003 was 40.7%, comparedprior year and $48.3 million and $20.2 million, respectively, over the preceding quarter.
The Company’s net earnings were $132.3 million, or $.73 per diluted share compared to $29.6 million, or $.16 per diluted share in the third quarter of fiscal year 2002.
In addition, the Company continues to measure its performance based on the calculation of earnings excluding the after-tax impact of amortization of acquired intangible assets and goodwill impairment. Net earnings, excluding the after-tax impact of these expenses, was $142.3 million, or $.78 per diluted share in the third quarter, compared to $39.4 million, or $.21 per diluted share in last year’s third quarter. This calculation is a non-GAAP financial measure.
Due to the seasonal nature of the Company’s business, results for the three months ended January 31, 2003 are not comparable to the three months ended October 31, 2002.prior year.
Consolidated H&R Block, Inc. — Nine-MonthSix-Month Results
| Nine months ended | ||||||||
| January 31, | January 31, | |||||||
| 2003 | 2002 | |||||||
| Revenues | $ | 1,861,175 | $ | 1,436,409 | ||||
| Pretax earnings (loss) | 144,783 | (49,041 | ) | |||||
| Net earnings (loss) | $ | 85,422 | $ | (29,179 | ) | |||
| Basic earnings (loss) per share | $ | .48 | $ | (.16 | ) | |||
| Diluted earnings (loss) per share | $ | .46 | $ | (.16 | ) | |||
-22-
| Six months ended | |||||||||
| October 31, 2003 | October 31, 2002 | ||||||||
| Revenues | $ | 1,085,545 | $ | 902,762 | |||||
| Pretax income (loss) | 35,963 | (78,151 | ) | ||||||
| Net income (loss) before change in accounting principle | 21,895 | (46,891 | ) | ||||||
| Cumulative effect of change in accounting principle | (6,359 | ) | — | ||||||
| Net income (loss) | $ | 15,536 | $ | (46,891 | ) | ||||
| Basic earnings (loss) per share: | |||||||||
| Before change in accounting principle | $ | .12 | $ | (.26 | ) | ||||
| Net income (loss) | $ | .09 | $ | (.26 | ) | ||||
| Diluted earnings (loss) per share: | |||||||||
| Before change in accounting principle | $ | .12 | $ | (.26 | ) | ||||
| Net income (loss) | $ | .09 | $ | (.26 | ) | ||||
Overview
NineA summary of the Company’s results for the six months ended JanuaryOctober 31, 2003 is as follows:
Consolidateda net loss of $46.9 million in the prior year.
The Company reportedServices’ pretax earnings of $144.8 million for the nine months ended January 31, 2003 comparedresults improved 52.1% due primarily to a loss of $49.0$24.0 million goodwill impairment charge recorded in the prior year, an improvement of $193.8 million. Mortgage Operations reported earnings of $563.1 million, an increase of $325.7 million over last year. Increased losses from U.S. Tax Operations, Investment Services and Business Services of $52.1 million, $65.0 million and $14.4 million, respectively, offset the improvement from Mortgage Operations.
The effective income tax rate for the nine months ended January 31, 2003 was 41.0%, compared to 40.5% and 39.4% for the nine months ended January 31, 2002 and full fiscal year 2002, respectively. The increase in the effective income tax rate over the full fiscal year 2002 is primarily the result of the non-deductible goodwill impairment charges recorded in the first nine months of fiscal year 2003. The full fiscal year 2002 effective tax rate of 39.4% was lower than the 40.5% effective tax rate recorded during the nine months ended January 31, 2002, primarily due to fourth quarter earnings in fiscal year 2002 exceeding the estimate on which the fiscal year 2002 effective tax rate was based.-30-
The Company’s net earnings were $85.4 million, or $.46 per diluted share compared to a loss of $29.2 million, or $.16 per diluted share for the nine months ended January 31, 2002. Net earnings of $85.4 million include pretax charges of $41.7 million for the Texas litigation reserve and $24.0 million in goodwill impairment, and a $130.9 million pretax gain on the sale of previously securitized residual interests. The after-tax impact of these items increased net earnings $38.5 million, or $.21 per diluted share.
Net earnings, excluding the after-tax impact of amortization of acquired intangible assets and goodwill impairment, were $139.5 million, or $.76 per diluted share for the nine months ended January 31, 2003, compared to a loss of $492 thousand for the nine months ended January 31, 2002.
U.S. Tax Operations
This segment is primarily engaged in providing tax return preparation, filing and related services in the United States. Segment revenues include fees earned for tax-related services performed at company-owned tax offices, and royalties from franchise offices. This segment also includes the Company’soffices, sales of tax preparation and other software, — TaxCut®fees from online tax preparation, and payments related to refund anticipation loan (RAL) participations.
TaxCut from H&R Block otherenables do-it-yourself users to prepare their federal and state tax returns easily and accurately. Several versions of the software are available to suit the needs of individual users, including TaxCut Standard, TaxCut Deluxe (includes free state and electronic filing), TaxCut Platinum for more complex returns and TaxCut Home & Business for small business owners. Other personal productivity software packages are also offered, including H&R Block Deduction Pro, WillPower and Home & Business Attorney.
Clients also have the option of online do-it-yourself tax preparation, online professional tax review, online tax advice and online tax preparation through a tax professional (whereby the client completes an online tax organizer and sends it to a tax professional for preparation), online do-it-yourself tax preparation, online professional tax review and online tax advice through thehrblock.com website. The Company participates in the Free File Alliance, formed in fiscal year 2003. This alliance was created by the industry and the Internal Revenue Service (IRS), and allows qualified lower-income filers to prepare and file their federal return online at no charge.
In addition,During the six months ended October 31, 2003, subsidiaries of the Company offers RAL productsbegan operating income tax return preparation businesses in the franchise territories previously operated by ten of its former major franchisees. As a result of these operations, the company expects to itshave 476 more company-owned and 238 more regular franchise offices for the upcoming tax clients throughseason. The final purchase prices are pending litigation or settlement. Preliminary purchase price allocations have been made and will be adjusted upon determination of the final purchase price. The results for the three and six months ended October 31, 2003 include compensation, occupancy, legal, amortization and other expenses related to the commencement of company-owned operations in the former franchise territories totaling $12.8 million and $13.2 million, respectively.
Financial results for the three months ended July 31, 2003 have been restated as a relationshipresult of the adoption of Emerging Issues Task Force Issue No. 00-21, “Revenue Arrangements with Household. In previous years,Multiple Deliverables” (EITF 00-21), as it relates to the Company purchased participation interests in RALs (49.9%Peace of Mind (POM) guarantee program. See note 13 to the condensed consolidated financial statements for additional information.
-23--31-
U.S. Tax Operations — Three-Month Results
| Three months ended | ||||||||||||||
| October 31, 2003 | October 31, 2002 | July 31, 2003 | ||||||||||||
| Tax preparation and related fees | $ | 12,792 | $ | 13,370 | $ | 11,839 | ||||||||
| Royalties | 1,651 | 1,402 | 1,036 | |||||||||||
| RAL waiver fees | 1,446 | — | 4,114 | |||||||||||
| Software sales | 933 | 560 | 260 | |||||||||||
| Online tax services | 430 | 242 | 556 | |||||||||||
| Peace of Mind revenue | 17,658 | 6,775 | 19,909 | |||||||||||
| Other | 12,279 | 11,080 | 2,808 | |||||||||||
| Total revenues | 47,189 | 33,429 | 40,522 | |||||||||||
| Compensation and benefits | 35,927 | 36,677 | 27,340 | |||||||||||
| Occupancy and equipment | 44,286 | 37,241 | 40,280 | |||||||||||
| Depreciation and amortization | 10,781 | 6,387 | 7,842 | |||||||||||
| Cost of software sales | 723 | 295 | 251 | |||||||||||
| Supplies, freight and postage | 3,947 | 4,204 | 1,183 | |||||||||||
| Legal | 11,101 | 45,947 | 3,782 | |||||||||||
| Other | 27,050 | 16,373 | 20,382 | |||||||||||
| Allocated corporate and shared costs: | ||||||||||||||
| Information technology | 22,908 | 18,524 | 19,655 | |||||||||||
| Marketing | 5,634 | 6,732 | 2,749 | |||||||||||
| Finance | 4,708 | 4,760 | 3,555 | |||||||||||
| Supply | 4,886 | 3,284 | 2,084 | |||||||||||
| Other | 6,176 | 5,304 | 4,591 | |||||||||||
| Total expenses | 178,127 | 185,728 | 133,694 | |||||||||||
| Pretax loss | $ | (130,938 | ) | $ | (152,299 | ) | $ | (93,172 | ) | |||||
Three months ended October 31, 2003 compared to October 31, 2002
U.S. Tax Operations’ revenues increased $13.8 million, or 41.2%, for RALs facilitated atthe three months ended October 31, 2003, compared to the three months ended October 31, 2002.
Tax preparation and related fees decreased $0.6 million, or 4.3%, for the three months ended October 31, 2003. This decrease is primarily due to a 2.6% decrease in the average charge, net of discounts, offset by a 7.3% increase in tax returns prepared. The net average charge decreased to $185.47 in the current quarter compared to $190.37 last year. Average charge is calculated as tax preparation and filing fees, less discounts if applicable, divided by the number of clients served. Tax returns prepared in company-owned offices and franchise offices and 25.0% for RALs facilitatedduring the current quarter were 75 thousand, compared to 70 thousand in major franchise offices). Revenue from participation was calculated as the Company’s percentage participation multiplied by a fee paid by the customer to Household. prior year.
During the third quarter of fiscal year 2003, the Company entered into an agreement with Household Tax Masters, Inc. (Household), whereby the Company waived its right to purchase any participation interests in and receive license fees for RALs during the period January 1 through April 30, 2003. In consideration for waiving suchthese rights the Company will receive, during such period,received a series of payments from Household totaling $133.0 millionin fiscal year 2003, subject to certain adjustments in fiscal year 2004 based on delinquency rates, with payments received under this arrangement recognized as revenue overrates. During the term ofthree months ended October 31, 2003 the waiver period. As of March 14, 2003, $124.5 million of the total waiver payments had been received.Company recorded
Due to the seasonal nature of this segment’s business, three and nine-month results are not indicative of the expected results for the entire fiscal year.
U.S. Tax Operations -Operating Statistics for company-owned operations(in 000s except average fee and offices)
| Period January 1 through January 31, | |||||||||
| 2003 | 2002 | ||||||||
| Tax returns prepared | 2,202 | 2,133 | |||||||
| Clients served: | |||||||||
| Company-owned offices | 2,218 | 2,152 | |||||||
| E-commerce | 239 | 143 | |||||||
| Tax returns filed electronically: | |||||||||
| Company-owned offices | 2,159 | 2,084 | |||||||
| E-commerce | 167 | 119 | |||||||
| Average fee per client served (in offices) | $ | 129.71 | $ | 120.89 | |||||
| Average fee per tax return (in offices) | $ | 106.94 | $ | 97.48 | |||||
| Refund anticipation loans (RALs): | |||||||||
| Company-owned offices (1) | 1,146 | 1,092 | |||||||
| E-commerce (1) | 19 | 8 | |||||||
| Offices | 5,279 | 5,017 | |||||||
-24--32-
U.S. Tax Operations — Three-Month Results
| Three months ended | ||||||||||||||
| January 31, | January 31, | October 31, | ||||||||||||
| 2003 | 2002 | 2002 | ||||||||||||
| Tax preparation and related fees | $ | 289,635 | $ | 270,024 | $ | 13,370 | ||||||||
| Royalties | 38,211 | 32,429 | 1,402 | |||||||||||
| RAL participation fees | 37 | 30,154 | 5 | |||||||||||
| RAL waiver fees | 31,676 | — | — | |||||||||||
| Software sales | 15,704 | 16,072 | 560 | |||||||||||
| Other | 28,308 | 23,195 | 18,092 | |||||||||||
| Total revenues | 403,571 | 371,874 | 33,429 | |||||||||||
| Compensation and benefits | 151,251 | 150,765 | 36,677 | |||||||||||
| Occupancy and equipment | 50,180 | 43,954 | 37,241 | |||||||||||
| Depreciation and amortization | 10,188 | 8,982 | 6,387 | |||||||||||
| Cost of software sales | 10,240 | 8,690 | 330 | |||||||||||
| Bad debt expense | 16,302 | 24,072 | 812 | |||||||||||
| Supplies, freight and postage | 13,454 | 7,903 | 4,204 | |||||||||||
| Texas litigation reserve | — | — | 41,672 | |||||||||||
| Other | 32,765 | 29,174 | 19,801 | |||||||||||
| Allocated corporate and shared costs: | ||||||||||||||
| Information technology | 21,896 | 18,020 | 18,524 | |||||||||||
| Marketing | 39,601 | 28,687 | 6,732 | |||||||||||
| Finance | 5,532 | 2,301 | 4,760 | |||||||||||
| Supply | 12,049 | 7,213 | 3,284 | |||||||||||
| Other | 5,976 | 16,833 | 5,304 | |||||||||||
| Total expenses | 369,434 | 346,594 | 185,728 | |||||||||||
| Pretax earnings (loss) | $ | 34,137 | $ | 25,280 | $ | (152,299 | ) | |||||||
Three months ended January 31, 2003 compared to January 31, 2002
U.S. Tax Operations’additional revenues increased $31.7of $1.4 million or 8.5%, to $403.6 million for the three months ended January 31, 2003, compared to the three months ended January 31, 2002.
Tax preparation and related fees increased $19.6��million, or 7.3%, to $289.6 million for the three months ended Januarybased on projected delinquency rates through December 31, 2003. This increaseThe waiver agreement with Household was a one-year agreement. The final payment is dueexpected to an 8.9% increasebe received in the average charge, netJanuary 2004, based on actual delinquency rates as of discounts, and a 3.3% increaseDecember 31, 2003. The Company intends to participate in tax returns prepared. The net average charge increased to $106.01 in 2003 compared to $97.37 in 2002. Average charge is calculated as tax preparation fees, less discounts if applicable, divided by the number of tax returns prepared. Tax returns prepared in company-owned officesRALs during the current quarter were 2.2 million, compared to 2.1 million in 2002.upcoming tax season.
Tax returns prepared and tax preparation revenues at franchise offices increased by 8.0% and 20.9%, respectively, resulting in an increase in royalty income of 17.8%.
Revenues earned during the current quarter in connection with the RAL waiver agreement totaled $31.7 million. These revenues are approximately $6.0 million lower than participation and related fees earned during the three months ended January 31, 2002.
-25-
A total of 1.3 million software units were sold during the quarter ended January 31, 2003, an increase of 10.8% compared to units sold of 1.2 million in the 2002 period. Revenues from software sales of $15.7 million in the fiscal 2003 quarter are slightly lower than revenues of $16.1 million in the 2002 period due to increases in rebates offered and customer rebate redemption rates.
OtherPOM revenues for the three months ended JanuaryOctober 31, 2003 were $28.3increased $10.9 million, a 22.0% improvement over 2002, principallyor 160.6%, due to anthe adoption of EITF 00-21. Prior to the adoption of EITF 00-21, revenues related to POM guarantees in premium offices were recorded within tax preparation revenues. With the adoption of EITF 00-21, the revenues are deferred and recognized over the guarantee period. The increase over the prior year is a result of $3.4 millionthe amortization of larger deferred revenue balances established as part of the cumulative effect of a change in supply sales to franchisees.accounting principle.
Total expenses for the three months ended JanuaryOctober 31, 2003 were $369.4$178.1 million, up $22.8down $7.6 million, or 6.6%4.1%, from 2002.the prior year. The decrease from the prior year is a result of a litigation settlement recorded in the prior year and effective off-season cost controls. These decreases were partially offset by additional costs from the commencement of company-owned operations in former major franchise territories. Legal expenses declined $34.8 million, or 75.8%, primarily due to the Texas RAL litigation reserve of $41.7 million recorded in the previous year, partially offset by legal costs incurred related to other open litigation. Occupancy and equipment costs increased $6.2$7.0 million over the prior year, due primarily to a 4.5% increaseincreases of 215 in the number ofcompany-owned offices under lease and a 5% increaseoffices related to the former major franchise territories. Depreciation and amortization expenses increased in average rents paid.conjunction with additional equipment purchased for new office locations opened during the period. Amortization of intangible assets increased $1.7 million due to the acquisition of assets from former major franchisees. Other expenses in the current quarter increased $3.6$10.7 million over 2002last year. The increase was primarily due to increased legal and marketing costs, partially offset by reduced servicing$5.6 million of additional POM expenses duerelated to the RAL waiver agreement. Allocated marketingadoption of EITF 00-21. Additionally, travel and consulting expenses increased $10.9by $1.6 million and $1.2 million, respectively. Information technology expenses increased $4.4 million, or 38.0%23.7%, to $39.6 million for the quarter ended JanuaryOctober 31, 2003, primarily due to accelerationadditional technology projects.
The pretax loss of certain tax season advertisements during the current period, which in the prior fiscal year occurred in the fourth quarter. Offsetting these increases, bad debt expense declined by $7.8 million as a result of $2.1 million collected on RAL receivables previously written off and the elimination of bad debt related to RAL participations. In the prior year, $5.1 million in RAL bad debt expense was recorded.
Pretax earnings of $34.1$130.9 million for the three months ended JanuaryOctober 31, 2003, representrepresents a 35.0%14.0% improvement over 2002 earningsthe prior year loss of $25.3$152.3 million.
Due to the seasonal nature of this segment’s business, operating results for the three months ended JanuaryOctober 31, 2003 are not comparable to the three months ended October 31, 2002.
Although tax returns prepared through JanuaryJuly 31, 2003 increased by 3.3% over the comparable 2002 period, returns prepared through February have declined. Tax returns prepared in company-owned offices during the period January 1 through February 28, 2003, declined 3.7% compared to the same period last year. Despite the decline in units, tax preparation and related fees for company-owned offices for the same period increased 4.1% compared to last year due to increases in the complexity of returns prepared and, consequently, the average charge.
-26-
U.S. Tax Operations — Nine-Month Results
| Nine months ended | ||||||||||
| January 31, | January 31, | |||||||||
| 2003 | 2002 | |||||||||
| Tax preparation and related fees | $ | 314,013 | $ | 291,814 | ||||||
| Royalties | 40,529 | 34,995 | ||||||||
| RAL participation fees | 319 | 30,450 | ||||||||
| RAL waiver fees | 31,676 | — | ||||||||
| Software sales | 17,135 | 17,567 | ||||||||
| Other | 56,614 | 44,089 | ||||||||
| Total revenues | 460,286 | 418,915 | ||||||||
| Compensation and benefits | 214,462 | 208,325 | ||||||||
| Occupancy and equipment | 124,611 | 110,908 | ||||||||
| Depreciation and amortization | 22,713 | 23,715 | ||||||||
| Cost of software sales | 10,923 | 9,461 | ||||||||
| Bad debt expense | 18,018 | 23,911 | ||||||||
| Supplies, freight and postage | 19,206 | 12,590 | ||||||||
| Texas litigation reserve | 41,672 | — | ||||||||
| Other | 64,465 | 52,266 | ||||||||
| Allocated corporate and shared costs: | ||||||||||
| Information technology | 56,122 | 51,184 | ||||||||
| Marketing | 51,402 | 38,839 | ||||||||
| Finance | 14,500 | 7,964 | ||||||||
| Supply | 17,634 | 12,626 | ||||||||
| Other | 16,750 | 27,239 | ||||||||
| Total expenses | 672,478 | 579,028 | ||||||||
| Pretax loss | $ | (212,192 | ) | $ | (160,113 | ) | ||||
Nine months ended January 31, 2003 compared to January 31, 2002
U.S. Tax Operations’ revenues increased $41.4 million, or 9.9%, to $460.3 million for the nine months ended January 31, 2003, compared to the nine months ended January 31, 2002.
Tax preparation and related fees increased $22.2 million, or 7.6%, to $314.0 million for the nine months ended January 31, 2003. The increase is due to an 8.6% increase in the average charge, net of discounts, on tax returns prepared. The net average charge increased to $109.89 in 2003 compared to $101.19 in 2002.
RAL participation fees declined as a result of the RAL waiver agreement.
Other revenues for the nine months ended January 31, 2003 were $56.6 million, an increase of $12.5 million, or 28.4%, over 2002. This improvement was primarily the result of an additional $7.1 million in deferred warranty revenues recognized and an increase of $4.5 million in supply sales to franchisees.
Total expenses for the nine months ended January 31, 2003 were $672.5 million, an increase of $93.5 million, or 16.1%. Increased expenses were primarily attributable to an estimated
-27-
settlement reserve of $41.7 million recorded during the second quarter of 2003 relating to Texas RAL litigation. Occupancy and equipment costs increased $13.7 million to $124.6 million in the current period, due to an increased number of offices under lease and increases in average rent. Other expenses increased $12.2 million to $64.5 million primarily due to increased legal, consulting and marketing expenses, partially offset by reduced servicing expenses due to the RAL waiver agreement. Allocated marketing expenses increased $12.6 million, or 32.3%, to $51.4 million for the quarter ended January 31, 2003, primarily due to acceleration of certain tax season advertisements into the current period, which in the prior fiscal year occurred in the fourth quarter. These increases were partially offset by a decline of $5.9 million in bad debt expense, due to collections of $2.1 million on receivables previously written off and the elimination of bad debt expense associated with RAL participations.
The pretax loss of $212.2 million for the nine months ended January 31, 2003, which includes the Texas ligation reserve charge of $41.7 million, was $52.1 million higher than the 2002 pretax loss of $160.1 million.
International Tax Operations
This segment is primarily engaged in providing local tax return preparation, filing and related services in Canada, Australia and the United Kingdom. In addition, Overseas operations include company-owned and franchise offices in eight countries that prepare U.S. tax returns for U.S. citizens living abroad. This segment served 2.3 million taxpayers in fiscal year 2002. Segment revenues include fees earned for tax-related services performed at company-owned tax offices and royalties from franchise offices.
The Company’s operations in this segment are transacted in the local currencies of the countries in which it operates; therefore, the results can be affected by the translation of local currency results into U.S. dollars. The strengthening of the U.S. dollar, primarily in Australia, during fiscal year 2003 had the effect of increasing revenues and decreasing losses compared to the prior year.
Due to the seasonal nature of this segment’s business, three and nine-month results are not indicative of the expected results for the entire fiscal year. The Canadian tax season is from January to April, the Australian tax season is from July to October and the United Kingdom’s tax season is from August to March.
-28--33-
InternationalU.S. Tax Operations — Three-MonthSix-Month Results
| Three months ended | |||||||||||||
| January 31, | January 31, | October 31, | |||||||||||
| 2003 | 2002 | 2002 | |||||||||||
| Canada | $ | 2,376 | $ | 2,625 | $ | 2,529 | |||||||
| Australia | 5,720 | 4,978 | 12,345 | ||||||||||
| United Kingdom | 435 | 238 | 329 | ||||||||||
| Overseas | 248 | 136 | 123 | ||||||||||
| Total revenues | 8,779 | 7,977 | 15,326 | ||||||||||
| Canada | (6,139 | ) | (5,308 | ) | (4,260 | ) | |||||||
| Australia | 1,243 | 1,151 | 5,030 | ||||||||||
| United Kingdom | (98 | ) | (314 | ) | (193 | ) | |||||||
| Overseas | (229 | ) | (220 | ) | (359 | ) | |||||||
| Allocated corporate and shared costs | (512 | ) | (551 | ) | (468 | ) | |||||||
| Pretax loss | $ | (5,735 | ) | $ | (5,242 | ) | $ | (250 | ) | ||||
| Six months ended | ||||||||||
| October 31, 2003 | October 31, 2002 | |||||||||
| Tax preparation and related fees | $ | 24,631 | $ | 24,378 | ||||||
| Royalties | 2,687 | 2,318 | ||||||||
| RAL waiver fees | 5,560 | — | ||||||||
| Software sales | 1,193 | 1,431 | ||||||||
| Online tax services | 986 | 519 | ||||||||
| Peace of Mind revenue | 37,567 | 14,326 | ||||||||
| Other | 15,087 | 13,743 | ||||||||
| Total revenues | 87,711 | 56,715 | ||||||||
| Compensation and benefits | 63,267 | 63,211 | ||||||||
| Occupancy and equipment | 84,566 | 74,431 | ||||||||
| Depreciation and amortization | 18,623 | 12,525 | ||||||||
| Cost of software sales | 974 | 569 | ||||||||
| Supplies, freight and postage | 5,130 | 5,752 | ||||||||
| Legal | 14,883 | 48,305 | ||||||||
| Other | 47,432 | 26,897 | ||||||||
| Allocated corporate and shared costs: | ||||||||||
| Information technology | 42,563 | 34,226 | ||||||||
| Marketing | 8,383 | 11,801 | ||||||||
| Finance | 8,263 | 8,968 | ||||||||
| Supply | 6,970 | 5,585 | ||||||||
| Other | 10,767 | 10,774 | ||||||||
| Total expenses | 311,821 | 303,044 | ||||||||
| Pretax loss | $ | (224,110 | ) | $ | (246,329 | ) | ||||
ThreeSix months ended JanuaryOctober 31, 2003 compared to JanuaryOctober 31, 2002
InternationalU.S. Tax Operations’ revenues increased $31.0 million, or 54.7%, for the threesix months ended JanuaryOctober 31, 2003, increased $0.8 million, or 10.1%, to $8.8 million, compared to the three months ended January 31, 2002. This improvement is primarily due to results in Australia, where tax returns prepared in the current quarter increased 2.3% compared to the prior year and the average charge per return increased 2.1%.
The pretax loss of $5.7 million for the quarter ended January 31, 2003, was 9.4% worse than the pretax loss of $5.2 million recorded in the third quarter last year. This decline is primarily due to an increased loss from Canadian operations due to higher bad debt, legal fees incurred for new business initiatives, and data communication costs.
Due to the seasonal nature of this segment’s business, operating results for the three months ended January 31, 2003 are not comparable to the threesix months ended October 31, 2002.
-29-Tax preparation and related fees increased slightly for the six months ended October 31, 2003, as a result of a 2.2% increase in the average charge, net of discounts, and a 1.7% increase in tax returns prepared. The net average charge increased to $171.36 in the current period compared to $167.68 last year. Tax returns prepared in company-owned offices during the current period were 162 thousand, compared to 159 thousand in the prior year.
During the six months ended October 31, 2003 the Company recorded revenues of $5.6 million in conjunction with the RAL waiver agreement with Household based on projected delinquency rates through December 31, 2003.
POM revenues for the six months ended October 31, 2003 increased $23.2 million, or 162.2%, principally due to the adoption of EITF 00-21.
-34-
International Tax Operations — Nine-Month Results
| Nine months ended | |||||||||
| January 31, | January 31, | ||||||||
| 2003 | 2002 | ||||||||
| Canada | $ | 7,710 | $ | 8,214 | |||||
| Australia | 18,957 | 16,468 | |||||||
| United Kingdom | 1,077 | 1,109 | |||||||
| Overseas | 644 | 659 | |||||||
| Total revenues | 28,388 | 26,450 | |||||||
| Canada | (14,629 | ) | (12,772 | ) | |||||
| Australia | 4,694 | 3,661 | |||||||
| United Kingdom | (429 | ) | (889 | ) | |||||
| Overseas | (685 | ) | (199 | ) | |||||
| Allocated corporate and shared costs | (1,387 | ) | (1,687 | ) | |||||
| Pretax loss | $ | (12,436 | ) | $ | (11,886 | ) | |||
NineTotal expenses for the six months ended JanuaryOctober 31, 2003 compared to January 31, 2002
International Tax Operations’ revenues for the nine months ended January 31, 2003 increased $1.9were $311.8 million, up $8.8 million, or 7.3%2.9%, from the prior year. The increase over the prior year is primarily a result of the costs of additional offices and the commencement of company-owned operations in former major franchise territories. These increased costs were offset by lower legal expenses as a result of a prior year litigation settlement, and effective off-season cost controls. Occupancy and equipment costs increased $10.1 million due to $28.4 million comparedincreases of 215 in company-owned offices under lease and offices related to the nine months ended January 31, 2002. This improvement is primarilyformer major franchise territories. Depreciation and amortization expenses increased in conjunction with additional equipment purchased for new office locations opened during the period. Amortization of intangible assets increased $1.7 million due to results in Australia, where tax returns preparedthe acquisition of assets from former major franchisees. Other expenses in the current period increased 3.3% compared$20.5 million over last year. The increase was primarily due to 2002,$11.8 million of additional POM expenses related to the adoption of EITF 00-21, and $4.2 million of additional interest accretion related to a legal settlement. Additionally, consultant fees and travel expenses increased $3.0 million and $1.4 million, respectively. Information technology expenses increased $8.3 million, or 24.4%, for the average charge per return increased 4.4%.six months ended October 31, 2003, primarily due to additional technology projects. Offsetting these increases, legal expenses declined $33.4 million, or 69.2%, primarily due to the Texas RAL litigation reserve of $41.7 million recorded in the previous year, partially offset by legal costs incurred related to other open litigation.
The pretax loss of $12.4$224.1 million for the ninesix months ended JanuaryOctober 31, 2003, is 4.6% greater thanrepresents a 9.0% improvement over the pretaxprior year loss of $11.9 million for the same period last year. The increased loss is primarily from Canadian operations, due to a decline in off-season tax revenue, and increases in bad debt, additional legal fees incurred for new business initiatives, and data communication costs. Canadian operating losses were partially offset by improved performance in Australia that was primarily attributable to increased volume.$246.3 million.
Mortgage Operations
Through Option One Mortgage Corporation and H&R Block Mortgage Corporation, thisThis segment is primarily engaged in the origination of non-prime mortgage loans, sales and salesecuritizations of mortgage assets and servicing of non-prime loans. Revenues consist of proceeds from sales and securitizations of loans and related assets, and provides servicing for non-prime loans. This segment engages in four principal activities: wholesale loan origination and sale, retail loan origination and sale,accretion on residual interests, loan servicing fees and capital markets. The Company manages this segment to optimize cash flows from operations while at the same time minimizing risks associated with loan performance.interest received on loans.
Wholesale loan origination and sale:This activity offers, through a network of mortgage brokers, a flexible product line to borrowers who are creditworthy but do not meet traditional underwriting criteria (non-prime). The primary source of revenue for this activity is the recognition of gains on sales of mortgage loans. The mortgage loans are sold daily in a whole loan sale to third-party trusts (Trusts), until they are ultimately disposed of, either through a securitization or sale to a third-party whole loan buyer by the Trusts.
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Retail loan origination and sale:This activity offers prime mortgage loan products, as well as non-prime mortgage loan products, through some H&R Block Financial Advisors branch offices, H&R Block Mortgage Corporation retail offices and through telemarketing operations. The primary source of revenue for this activity is the recognition of gains on sales of mortgage loans. Prime mortgage loans are sold in whole loan sales to third-party buyers, and non-prime loans are sold to the Trusts for disposition, either through a securitization or sale to a third-party whole loan buyer by the Trusts.
Loan servicing:This activity primarily servicesSubstantially all non-prime mortgage loans originated from wholesale and retail operations.are sold daily to qualifying special purpose entities (Trusts). The primary source of revenue for this activity isCompany removes the recognition of servicing and late fee income.
Capital markets activity:This activity includes residual interests in securitized mortgage loans from its balance sheet and records the gain on the sale, cash and a receivable which represents the ultimate expected outcome from the disposition of the loans by the Trusts. The Trusts, as directed by the third-party beneficial interest holders, either sell the loans directly to third-party investors or back to the Company’s securitization entity to pool the loans for securitization, depending on market conditions.
In a securitization transaction, the Trusts transfer the loans to a special purpose entity, which is a consolidated subsidiary of the Company, and the Company simultaneously transfers the loans and its receivable, and the right to receive all payments on the loans, to a securitization trust. The securitization trust meets the definition of a qualifying special purpose entity (QSPE) and is therefore not consolidated by the Company. The securitization trust issues bonds, which are supported by cash flows are received overfrom the life ofpooled loans, to third-party investors. The Company retains an interest in the loans. These residual interests are subsequently securitizedloans in the form of a residual interest (including overcollateralization (OC) accounts and uncertificated interests) and usually assumes first risk of loss for credit losses in the loan pool. As the cash flows of the underlying loans and market conditions change, the value of
-35-
the Company’s residual interests may also change, resulting in either additional unrealized gains or impairment of the residual interests.
To accelerate cash flows from its residual interests, the Company securitizes the majority of its residual interests in net interest margin (NIM) transactions. In a NIM transaction, residual interests are normally transferred to another QSPE (NIM trust), which then issues bonds to third-party investors. In the second quarter of fiscal year 2004, the Company completed a NIM transaction with a special purpose entity (SPE) that did not qualify as a QSPE and, result intherefore the receipt ofSPE has been consolidated and the transaction was accounted for as a substantial portion of the cashsecured financing (on-balance sheet securitization).
Proceeds from the bonds are returned to the Company as payment for the residual interest at the closinginterests. The bonds are secured by pooled residual interests and are obligations of the NIM transaction, rather than overtrust. The Company retains a subordinated interest in the actual life ofNIM trust, and receives cash flows on its residual interest generally after the loans. Residualsbonds issued to the third-party investors are paid in full. Residual interests retained from NIM securitizations may also be bundled and sold in a subsequent securitization once the NIM bondholderssecuritization.
Substantially all non-prime loans originated and subsequently sold or securitized are paid. The primary sourcetransferred with servicing rights retained. Servicing activities include processing of revenue for this activity consists of accretion of residual interestsmortgage loan payments and the administration of mortgage loans, with loan servicing fees received monthly over the life of the mortgage loans. The Company has traditionally received a servicing fee of 50 basis points per annum on the outstanding principal balance of loans sold or securitized, as well as the right to receive certain ancillary income including, but not limited to, late fees. In recent transactions, step-servicing fee structures have been implemented. The purpose of step-servicing is to better match the stream of incoming servicing revenues against the related servicing expenses. Generally, the cost to service a pool of loans is lower immediately after origination and increases as the related loan pool ages. Recent step-servicing fee structures provide the company with a servicing fee of 30 basis points per annum for the first 10 months of servicing, 40 basis points per annum for the next 20 months of servicing and 65 basis points for the remainder of the servicing term.
Prime mortgage loans are sold in whole loan sales, servicing rights released, to third-party buyers.
Market interest rates have begun to increase after a sustained period of declining rates. In a rising interest rate environment the Company expects its profit margins will narrow from their historically high levels due to less favorable loan execution pricing. Actual execution pricing on sales of mortgage assets declined to 3.87% during the three months ended October 31, 2003 compared to 4.78% in the prior year. As such, growth in pretax income for the mortgage operations segment is expected to be more moderate or perhaps decline from results (excluding a $130.9 million gain on sale of NIM residual interests. Offsetting these revenues are realized write-downs of residual interests, which are recorded as reductions of revenues.interests) for the fiscal year ended April 30, 2003.
One of the Company’s core strategic objectives is creating a financial partnership with its tax clients through delivery of advice, coupled with the products and services needed to act on that advice. The Company’s initiative to serve the mortgage needs of its tax clients through its retail mortgage operations resulted in 42.6% of all retail loans, and 8.1% of all loans originated during the quarter, coming from H&R Block tax clients, compared to 39.6% and 7.5%, respectively, in the same period last year. In its February 24, 2003 press release announcing third quarter financial results, the Company reported that 42.5% of all retail loans and 10.6% of all loans originated during the quarter came from H&R Block tax clients. The press release posted on the Company’s website has been corrected to reflect the 42.6% and 8.1% actual results reported above.
-31--36-
Mortgage Operations — Three-Month Operating Statistics
| Three months ended | ||||||||||||||
| January 31, | January 31, | October 31, | ||||||||||||
| 2003 | 2002 | 2002 | ||||||||||||
| Number of loans originated: | ||||||||||||||
| Wholesale (non-prime) | 25,061 | 17,344 | 21,536 | |||||||||||
| Retail: | ||||||||||||||
| Prime | 3,560 | 2,229 | 3,089 | |||||||||||
| Non-prime | 2,284 | 1,827 | 2,754 | |||||||||||
| Total | 30,905 | 21,400 | 27,379 | |||||||||||
| Volume of loans originated: | ||||||||||||||
| Wholesale (non-prime) | $ | 3,756,809 | $ | 2,346,687 | $ | 3,083,895 | ||||||||
| Retail: | ||||||||||||||
| Prime | 496,176 | 337,993 | 444,469 | |||||||||||
| Non-prime | 280,738 | 211,119 | 351,694 | |||||||||||
| Total | $ | 4,533,723 | $ | 2,895,799 | $ | 3,880,058 | ||||||||
| Loan sales | $ | 4,599,255 | $ | 2,868,690 | $ | 3,821,649 | ||||||||
| Number of loans serviced (millions) | 233.0 | 202.4 | 220.8 | |||||||||||
| Average servicing portfolio (billions) | $ | 26.9 | $ | 20.3 | $ | 26.2 | ||||||||
| Closing ratio (2) | 57.3 | % | 50.7 | % | 49.8 | % | ||||||||
| Weighted average FICO score (2) | 605.9 | 596.7 | 604.3 | |||||||||||
| Execution price — Net gain on sale (1), (2) | 4.60 | % | 3.82 | % | 4.78 | % | ||||||||
| Weighted average coupon rate for borrowers (2) | 7.94 | % | 8.82 | % | 8.24 | % | ||||||||
| Weighted average loan-to-value (2) | 78.6 | % | 77.7 | % | 79.1 | % | ||||||||
| Three months ended | ||||||||||||||
| October 31, 2003 | October 31, 2002 | July 31, 2003 | ||||||||||||
| Number of loans originated: | ||||||||||||||
| Wholesale (non-prime) | 36,233 | 21,536 | 28,494 | |||||||||||
| Retail: Prime | 1,944 | 3,089 | 4,005 | |||||||||||
| Non-prime | 4,110 | 2,754 | 3,004 | |||||||||||
| Total | 42,287 | 27,379 | 35,503 | |||||||||||
| Volume of loans originated: | ||||||||||||||
| Wholesale (non-prime) | $ | 5,603,118 | $ | 3,083,895 | $ | 4,405,224 | ||||||||
| Retail: Prime | 247,661 | 444,469 | 540,326 | |||||||||||
| Non-prime | 492,977 | 351,694 | 365,331 | |||||||||||
| Total | $ | 6,343,756 | $ | 3,880,058 | $ | 5,310,881 | ||||||||
| Loan sales | $ | 6,330,449 | $ | 3,821,649 | $ | 5,301,341 | ||||||||
Weighted average FICO score(2) | 611 | 604 | 607 | |||||||||||
Execution price — Net gain on sale(1) | 3.87 | % | 4.78 | % | 4.42 | % | ||||||||
Weighted average interest rate for borrowers(2) | 7.51 | % | 8.24 | % | 7.54 | % | ||||||||
Weighted average loan-to-value(2) | 78.2 | % | 79.1 | % | 78.3 | % | ||||||||
| (1) | Defined as total premium received divided by total balance of loans delivered to third party investors or securitization vehicles (excluding mortgage servicing | |
| (2) | Represents non-prime production. |
-32-Mortgage Operations — Three-Month Results
| Three months ended | ||||||||||||||
| October 31, 2003 | October 31, 2002 | July 31, 2003 | ||||||||||||
| Components of gains on sales: | ||||||||||||||
| Gains on sales of mortgage assets | $ | 220,652 | $ | 155,079 | $ | 203,382 | ||||||||
| Impairment of residual interests | (363 | ) | (3,702 | ) | (10,743 | ) | ||||||||
| Total gains on sales | 220,289 | 151,377 | 192,639 | |||||||||||
| Loan servicing revenue | 51,659 | 41,325 | 48,317 | |||||||||||
| Accretion income | 36,843 | 54,092 | 34,063 | |||||||||||
| Interest income | 41,858 | 27,429 | 27,274 | |||||||||||
| Other | 507 | 365 | 602 | |||||||||||
| Total revenues | 351,156 | 274,588 | 302,895 | |||||||||||
| Compensation and benefits | 77,152 | 62,226 | 65,483 | |||||||||||
| Servicing and processing | 26,609 | 16,606 | 25,251 | |||||||||||
| Occupancy and equipment | 12,589 | 10,364 | 11,558 | |||||||||||
| Bad debt expense | 12,226 | 3,296 | 9,514 | |||||||||||
| Other | 38,554 | 28,576 | 27,260 | |||||||||||
| Total expenses | 167,130 | 121,068 | 139,066 | |||||||||||
| Pretax income | $ | 184,026 | $ | 153,520 | $ | 163,829 | ||||||||
-37-
Mortgage Operations — Three-Month Operating Results
| Three months ended | |||||||||||||||
| January 31, | January 31, | October 31, | |||||||||||||
| 2003 | 2002 | 2002 | |||||||||||||
| Components of gain on sale: | |||||||||||||||
| Gain on sale of mortgage assets: | |||||||||||||||
| Mortgage loans and related assets | $ | 176,940 | $ | 120,971 | $ | 155,079 | |||||||||
| Residual interests previously securitized | 130,881 | — | — | ||||||||||||
| Write-downs of residual interests | (1,457 | ) | (13,089 | ) | (3,702 | ) | |||||||||
| Total gain on sale | 306,364 | 107,882 | 151,377 | ||||||||||||
| Accretion income: | |||||||||||||||
| Residual interests | 11,157 | 5,041 | 16,768 | ||||||||||||
| Realized gains on residual write-ups | 9,136 | 11,301 | 37,324 | ||||||||||||
| Total accretion income | 20,293 | 16,342 | 54,092 | ||||||||||||
| Interest income | 26,357 | 20,508 | 27,429 | ||||||||||||
| Loan servicing revenue | 43,372 | 34,335 | 41,325 | ||||||||||||
| Other | 594 | 684 | 365 | ||||||||||||
| Total revenues | 396,980 | 179,751 | 274,588 | ||||||||||||
| Compensation and benefits | 68,442 | 45,121 | 62,226 | ||||||||||||
| Variable servicing and processing | 20,331 | 26,252 | 16,606 | ||||||||||||
| Occupancy and equipment | 10,986 | 7,557 | 10,364 | ||||||||||||
| Interest expense | 871 | 937 | 844 | ||||||||||||
| Bad debt expense | 5,898 | 5,386 | 3,296 | ||||||||||||
| Other | 25,746 | 15,667 | 26,785 | ||||||||||||
| Allocated corporate and shared costs | 2,240 | 1,404 | 947 | ||||||||||||
| Total expenses | 134,514 | 102,324 | 121,068 | ||||||||||||
| Pretax earnings | $ | 262,466 | $ | 77,427 | $ | 153,520 | |||||||||
Three months ended JanuaryOctober 31, 2003 compared to JanuaryOctober 31, 2002
Mortgage Operations’ revenues increased $217.2$76.6 million, or 120.8%27.9%, to $397.0 million for the three months ended JanuaryOctober 31, 2003 compared to the prior year. During the current period, the Company completed the sale of $206.6 million of residual interests from prior securitizations, resulting in a gain on sale of $130.9 million. Revenue increased primarily as a result of this gain and higher production volumes.
The following table summarizes the key drivers of gains on the salesales of mortgage loans.loans:
| Three months ended October 31, | ||||||||
| 2003 | 2002 | |||||||
Number of sales associates(1) | 2,476 | 2,005 | ||||||
| Total number of applications | 72,858 | 55,026 | ||||||
Closing ratio(2) | 58.0 | % | 49.8 | % | ||||
| Total number of originations | 42,287 | 27,379 | ||||||
| Average loan size | $ | 150 | $ | 142 | ||||
| Total originations | $ | 6,343,756 | $ | 3,880,058 | ||||
| Non-prime / prime ratio | 24.6 : 1 | 7.7 : 1 | ||||||
| Commitments to fund loans | $ | 3,244,958 | $ | 2,221,671 | ||||
| Loan sales | $ | 6,330,449 | $ | 3,821,649 | ||||
| Gains on sales of mortgage assets | $ | 220,652 | $ | 155,079 | ||||
Execution price — net gain on sale(3) | 3.87 | % | 4.78 | % | ||||
Gain
| (1) | Includes all direct sales and back office sales support associates. | |
| (2) | Percentage of loans funded divided by total applications. | |
| (3) | Defined as total premium received divided by total balance of loans delivered to third party investors or securitization vehicles (excluding mortgage servicing rights and the effect of loan origination expenses). |
Gains on salesales of mortgage loans and related assets for both wholesale and retail increased $56.0 million to $176.9$65.6 million for the three months ended JanuaryOctober 31, 2003. The increase over last year is a result of a significant increase in loan origination volume, partially offset by a decrease in loan sale execution pricing and an increase in loan sale execution pricing.origination expenses. During the thirdsecond quarter, the Company originated $4.5$6.3 billion in mortgage loans compared to $2.9$3.9 billion last year, an increase of 56.6%63.5%. The execution price on mortgage loan sales increasedloans originated and sold decreased to 4.60%3.87% for the current quarter compared to 3.82%4.78% last year, primarily due to decliningas a result of a decrease in the average interest ratesrate during the period.
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Write-downsImpairments of residual interests in securitizations of $1.5$0.4 million were recognized in the current period, duecompared to a decline in value of older residuals based on loan performance. Write-downs of residuals$3.7 million for the three months ended JanuaryOctober 31, 2002 totaled $13.1 million.2002.
AccretionThe following table summarizes the key drivers of loan servicing revenues:
| Three months ended October 31, | ||||||||
| 2003 | 2002 | |||||||
| Number of loans serviced | 295,636 | 220,842 | ||||||
| Average servicing portfolio | $ | 36,825,033 | $ | 26,141,181 | ||||
| Average delinquency rate | 6.28 | % | 7.21 | % | ||||
| Value of MSRs | $ | 111,960 | $ | 99,774 | ||||
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Loan servicing revenues increased $10.3 million, or 25.0%, compared to the prior year. The increase reflects a higher loan servicing portfolio. The average servicing portfolio for the three-month period ended October 31, 2003 increased $10.7 billion, or 40.9%, to $36.8 billion.
Total accretion of residual interests of $11.2$36.8 million for the fiscal 2003 third quarter represents an increase of $6.1 million over 2002 quarterly accretion of $5.0 million. This increase is due to added residual interests from loan sale activity. Accretion of realized gains on residual write-ups of $9.1 million were recorded during the three months ended JanuaryOctober 31, 2003 declining slightlyrepresents a decrease of $17.2 million from $11.3 million in the year-ago quarter. The decrease inprior year accretion of the related assets$54.1 million. This decline is due to a lower average balance of related residuals, resulting primarily from the sale of previously securitized residual interests.
Duringinterests (NIM residuals) during the third quarter of fiscal year 2003,2003.
During the second quarter of fiscal year 2004, the Company’s residual interests continued to perform better than expected compared to internal valuation models, primarily due to lower interest rates. The lower marketsustained low interest rates resulted in a reduction in the required interest payments due bondholders, thereby allowing the NIM bondholders and residual interest holders to receive cash related to principalmore favorable prepayment and interest payments, respectively, earlier than expected in the Company’s valuation models.loss rates. As a result of these items, the Company recorded pretax mark-to-market write-up adjustments,write-ups, which increased the fair value of its residual interests $40.9$20.9 million during the quarter. These write-ups were recorded, net of write-downs of $10.4 million and deferred taxes of $15.6$4.0 million, in other comprehensive income and will be accreted into income throughout the remaining life of those residual interests. Future changes in interest rates or other assumptions, based on market conditions or actual loan pool performance, could cause additional adjustments to the fair value of the residual interests and could cause changes to the accretion of these residual interests in future periods. Additionally, sales of NIM residual interests would result in decreases to accretion income in future periods.
Interest income increased $5.8$14.4 million, to $26.4 millionor 52.6%, for the quarter ended JanuaryOctober 31, 2003, primarily due to an increase in the average balance on loans held by the Trusts increasing to $1.9 billion from $1.2 billion in the prior-year quarter.Trusts. This increase was slightly offset by lower excess retained interest. The excess retained interest is what the Company earns on its receivable from the third-party Trusts, andmargin earned. Interest margin is the difference between the rate on the underlying loans and the financing costs of the Trusts during the time period the Trusts hold the loans prior to final disposition of the loans.Trusts. The interest rate margin on the receivable decreased to 5.72% during5.39% for the three months ended JanuaryOctober 31, 2003, from 6.05%5.64% a year ago.
Loan servicing revenues increased $9.0 million, or 26.3%, to $43.4 million this year. The increase reflects a higher loan servicing portfolio. The average servicing portfolio for the three-month period ended January 31, 2003 increased $6.6 billion, or 32.6%, to $26.9 billion.
Total expenses for the three months ended JanuaryOctober 31, 2003, increased $32.2$46.1 million, or 31.5%38.0%, over the year-ago quarter. This increase is primarily due to $14.9 million in increased compensation and benefits as a result of additional employeesa 23.5% increase in sales associates needed to support higher loan production volumes. Variable servicingServicing and processing expenses declinedincreased by $5.9$10.0 million due to reserves foras a result of a higher average servicing assets recordedportfolio during the three months ended JanuaryOctober 31, 2003. Occupancy and equipment charges increased $2.2 million due to nine additional branch offices opened since the prior year quarter ended, continued expansion of the second servicing center that opened in August 2002 and additional administrative office space. Bad debt expense increased $8.9 million primarily due to more whole loan sales than securitizations in the current year, for which did not reoccurhigher reserves are set up at the time of sale for estimated repurchases. Whole loan sales accounted for 79% of total loan sales, compared to 72% in fiscal year 2003.the prior year. Other expenses increased by $10.0 million to $25.7$38.6 million for the current quarter, primarily due to $2.0 million in increased depreciation, marketing expenses and consulting expenses.$4.5 million in increased allocated corporate and shared costs. Allocated costs increased as a result of additional insurance costs and the expensing of stock-based compensation.
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Pretax earningsincome increased $185.0$30.5 million to $262.5$184.0 million for the three months ended JanuaryOctober 31, 2003.
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Three months ended JanuaryOctober 31, 2003 compared to OctoberJuly 31, 20022003
Mortgage Operations’ revenues increased $122.4$48.3 million, or 44.6%15.9%, for the three months ended JanuaryOctober 31, 2003, compared to the preceding quarter.
The improvement is primarily due tofollowing table summarizes the gainkey drivers of $130.9 milliongains on the salesales of residual interests previously securitized, offset by reduced accretionmortgage loans:
| (dollars in 000s) | Three months ended | |||||||
| October 31, 2003 | July 31, 2003 | |||||||
Number of sales associates(1) | 2,476 | 2,330 | ||||||
| Total number of applications | 72,858 | 62,544 | ||||||
Closing ratio(2) | 58.0 | % | 56.8 | % | ||||
| Total number of originations | 42,287 | 35,503 | ||||||
| Average loan size | $ | 150 | $ | 150 | ||||
| Total originations | $ | 6,343,756 | $ | 5,310,881 | ||||
| Non-prime / prime ratio | 24.6 : 1 | 8.8 : 1 | ||||||
| Commitments to fund loans | $ | 3,244,958 | $ | 2,900,917 | ||||
| Loan sales | $ | 6,330,449 | $ | 5,301,341 | ||||
| Gains on sales of mortgage assets | $ | 220,652 | $ | 203,382 | ||||
Execution price — net gain on sale(3) | 3.87 | % | 4.42 | % | ||||
| (1) | Includes all direct sales and back office sales support associates. | |
| (2) | Percentage of loans funded divided by total applications. | |
| (3) | Defined as total premium received divided by total balance of loans delivered to third party investors or securitization vehicles (excluding mortgage servicing rights and the effect of loan origination expenses). |
Gains on the lower value of residual interests.
Gain on salesales of mortgage loans and related assets for both wholesale and retail increased $21.9$17.3 million to $176.9$220.7 million for the current quarter. This increase from the preceding quarter is primarily a result of a 16.8%19.4% increase in loans originated, which was partially offset by a decrease in execution price on loans originated and sold.loan sales as a result of the rising interest rate environment. The execution price on loans originated and soldloan sales for the quarter declineddecreased to 4.60%3.87% from 4.78%4.42% for the three months ended OctoberJuly 31, 2002, primarily as a result of a decrease in the average coupon rate.2003.
Write-downsImpairments of residual interests in securitizations of $1.5$0.4 million were recognized during the thirdsecond quarter, duecompared to $10.7 million for the three months ended July 31, 2003. The first quarter impairments resulted from a decline in value of older residuals based on loan performance. Write-downs on residuals for
The following table summarizes the three months ended October 31, 2002 totaled $3.7 million.key drivers of loan servicing revenues:
| (dollars in 000s) | Three months ended | |||||||
| October 31, 2003 | July 31, 2003 | |||||||
| Number of loans serviced | 295,636 | 261,344 | ||||||
| Average servicing portfolio | $ | 36,825,033 | $ | 32,757,225 | ||||
| Average delinquency rate | 6.28 | % | 6.60 | % | ||||
| Value of MSRs | $ | 111,960 | $ | 106,056 | ||||
Accretion of residual interests of $11.2 million represents a decrease of 33.5% from the preceding quarter accretion of $16.8 million. This decline is the result of the sale of residual interests previously securitized. Accretion of realized gains on residual write-ups declined $28.2 million to $9.1 million for the three months ended January 31, 2003 compared to $37.3 million for the preceding quarter, also due to the sale of residual interests previously securitized during the current period.
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Loan servicing revenues increased $2.0$3.3 million, or 5.0%6.9%, to $43.4 million, compared to the second quarter.first quarter of fiscal year 2004. The increase reflects a higher loan-servicing portfolio. The average servicing portfolio for the three months ended JanuaryOctober 31, 2003 increased $641$4.1 billion, or 12.4%, to $36.8 billion.
Accretion of residual interests of $36.8 million represents an increase of 8.2% from the preceding quarter accretion of $34.1 million, primarily due to write-ups taken during the first quarter of fiscal year 2004.
Interest income increased $14.6 million, or 2.4%53.5%, for the quarter ended October 31, 2003, due to $26.9 billion.an increase in the average balance on loans held by the Trusts. This increase was offset by lower interest margin earned. The interest margin decreased to 5.39% during the three months ended October 31, 2003, from 5.51% in the first quarter.
Total expenses increased $13.4$28.1 million, or 11.1%20.2%, primarily due to increased compensation and benefit costs associated with the increase in sales associates. Bad debt expense increased $2.7 million primarily due to amore whole loan sales than securitizations in the current quarter, which requires higher numberreserves to be set up at the time of employees neededsale for estimated repurchases. Whole loan sales accounted for 79% of total loan sales, compared to support increasing loan production volumes,57% in the first quarter. Other expenses also increased $11.3 million due to $2.7 million of additional marketing expenses, $2.3 million in additional consulting expenses and $1.2 million of additional depreciation and amortization. Allocated corporate and shared costs also increased $2.5 million, primarily due to increased servicinginsurance costs and processing expenses.the expensing of stock-based compensation.
Pretax earningsincome increased $108.9$20.2 million, or 71.0%12.3%, for the three months ended JanuaryOctober 31, 2003 compared to the preceding quarter, primarily due to the gain on sale of residual interests previously securitized.quarter.
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Mortgage Operations — Nine-Month OperatingSix-Month Statistics(in 000s except # of loans originated and serviced, and servicing portfolio)
| Nine months ended | ||||||||||
| January 31, | January 31, | |||||||||
| 2003 | 2002 | |||||||||
| Number of loans originated: | ||||||||||
| Wholesale (non-prime) | 67,371 | 53,515 | ||||||||
| Retail: | ||||||||||
| Prime | 8,548 | 6,070 | ||||||||
| Non-prime | 7,417 | 5,033 | ||||||||
| Total | 83,336 | 64,618 | ||||||||
| Volume of loans originated: | ||||||||||
| Wholesale (non-prime) | $ | 9,677,763 | $ | 6,673,256 | ||||||
| Retail: | ||||||||||
| Prime | 1,194,685 | 929,477 | ||||||||
| Non-prime | 914,722 | 561,211 | ||||||||
| Total | $ | 11,787,170 | $ | 8,163,944 | ||||||
| Volume of loans acquired | $ | 633,953 | $ | — | ||||||
| Loan sales: | ||||||||||
| Loans originated and sold | $ | 11,778,634 | $ | 8,191,794 | ||||||
| Loans acquired and sold | 633,953 | — | ||||||||
| Total | $ | 12,412,587 | $ | 8,191,794 | ||||||
| Number of loans serviced (millions) | 233.0 | 191.7 | ||||||||
| Average servicing portfolio (billions) | $ | 26.3 | $ | 19.5 | ||||||
| Closing ratio (2) | 53.2 | % | 50.9 | % | ||||||
| Weighted average FICO score (2) | 603.0 | 599.9 | ||||||||
| Execution price — Net gain on sale: (1) | ||||||||||
| Loans originated and sold (2) | 4.75 | % | 4.74 | % | ||||||
| Loans acquired and sold | .18 | % | — | |||||||
| Total loans sold | 4.49 | % | 4.74 | % | ||||||
| Weighted average coupon rate for borrowers (2) | 8.30 | % | 9.22 | % | ||||||
| Weighted average loan-to-value (2) | 78.9 | % | 78.5 | % | ||||||
| (dollars in 000s) | Six months ended | |||||||||
| October 31, 2003 | October 31, 2002 | |||||||||
| Number of loans originated: | ||||||||||
| Wholesale (non-prime) | 64,727 | 42,310 | ||||||||
| Retail: Prime | 5,949 | 4,988 | ||||||||
| Non-prime | 7,114 | 5,133 | ||||||||
| Total | 77,790 | 52,431 | ||||||||
| Volume of loans originated: | ||||||||||
| Wholesale (non-prime) | $ | 10,008,341 | $ | 5,920,954 | ||||||
| Retail: Prime | 787,987 | 698,509 | ||||||||
| Non-prime | 858,308 | 633,984 | ||||||||
| Total | $ | 11,654,636 | $ | 7,253,447 | ||||||
| Loan sales: | ||||||||||
| Loans originated and sold | $ | 11,631,790 | $ | 7,179,379 | ||||||
| Loans acquired and sold | — | 633,953 | ||||||||
| Total | $ | 11,631,790 | $ | 7,813,332 | ||||||
Weighted average FICO score(2) | 609 | 601 | ||||||||
Execution price — Net gain on sale(1) | 4.18 | % | 4.83 | % | ||||||
| Loans originated and sold | 4.18 | % | 4.83 | % | ||||||
| Loans acquired and sold | — | % | 0.18 | % | ||||||
| Total | 4.18 | % | 4.44 | % | ||||||
Weighted average interest rate for borrowers(2) | 7.53 | % | 8.52 | % | ||||||
Weighted average loan-to-value(2) | 78.2 | % | 79.1 | % | ||||||
| (1) | Defined as total premium received divided by total balance of loans delivered to third party investors or securitization vehicles (excluding mortgage servicing | |
| (2) | Represents non-prime production. |
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Mortgage Operations — Nine-Month OperatingSix-Month Results
| Nine months ended | ||||||||||
| January 31, | January 31, | |||||||||
| 2003 | 2002 | |||||||||
| Components of gain on sale: | ||||||||||
| Gain on sale of mortgage assets: | ||||||||||
| Mortgage loans and related assets | $ | 497,457 | $ | 351,944 | ||||||
| Residual interests previously securitized | 130,881 | — | ||||||||
| Write-downs of residual interests | (25,589 | ) | (29,642 | ) | ||||||
| Total gain on sale | 602,749 | 322,302 | ||||||||
| Accretion income: | ||||||||||
| Residual interests | 43,887 | 17,995 | ||||||||
| Realized gains on residual write-ups | 69,259 | 11,301 | ||||||||
| Total accretion income | 113,146 | 29,296 | ||||||||
| Interest income | 80,623 | 54,743 | ||||||||
| Loan servicing revenue | 123,647 | 100,378 | ||||||||
| Other | 1,709 | 2,178 | ||||||||
| Total revenues | 921,874 | 508,897 | ||||||||
| Compensation and benefits | 183,637 | 129,588 | ||||||||
| Variable servicing and processing | 51,958 | 53,282 | ||||||||
| Occupancy and equipment | 28,924 | 21,175 | ||||||||
| Interest expense | 2,544 | 4,126 | ||||||||
| Bad debt expense | 15,015 | 17,452 | ||||||||
| Other | 71,956 | 43,671 | ||||||||
| Allocated corporate and shared costs | 4,769 | 2,206 | ||||||||
| Total expenses | 358,803 | 271,500 | ||||||||
| Pretax earnings | $ | 563,071 | $ | 237,397 | ||||||
| (in 000s) | Six months ended | |||||||||
| October 31, 2003 | October 31, 2002 | |||||||||
| Components of gains on sales: | ||||||||||
| Gains on sales of mortgage assets | $ | 424,034 | $ | 320,517 | ||||||
| Impairment of residual interests | (11,106 | ) | (24,132 | ) | ||||||
| Total gains on sales | 412,928 | 296,385 | ||||||||
| Loan servicing revenue | 99,976 | 80,275 | ||||||||
| Accretion income | 70,906 | 92,853 | ||||||||
| Interest income | 69,132 | 54,266 | ||||||||
| Other | 1,109 | 1,115 | ||||||||
| Total revenues | 654,051 | 524,894 | ||||||||
| Compensation and benefits | 142,635 | 115,195 | ||||||||
| Servicing and processing | 51,860 | 31,627 | ||||||||
| Occupancy and equipment | 24,147 | 17,938 | ||||||||
| Bad debt expense | 21,740 | 9,117 | ||||||||
| Other | 65,814 | 50,412 | ||||||||
| Total expenses | 306,196 | 224,289 | ||||||||
| Pretax income | $ | 347,855 | $ | 300,605 | ||||||
NineSix months ended JanuaryOctober 31, 2003 compared to JanuaryOctober 31, 2002
Mortgage Operations’ revenues increased $413.0$129.2 million, or 81.2%24.6%, to $921.9 million for the ninesix months ended JanuaryOctober 31, 2003 compared to the prior year. Revenue increases areincreased primarily due toas a result of higher production volumes.
The following table summarizes the $130.9 million gainkey drivers of gains on the sale of residual interests previously securitized and an increase in gain on salesales of mortgage loans.loans:
| (dollars in 000s) | Six months ended October 31, | |||||||
| 2003 | 2002 | |||||||
Number of sales associates(1) | 2,476 | 2,005 | ||||||
| Total number of applications | 135,402 | 102,661 | ||||||
Closing ratio(2) | 57.5 | % | 51.1 | % | ||||
| Total number of originations | 77,790 | 52,431 | ||||||
| Average loan size | $ | 150 | $ | 138 | ||||
| Total originations | $ | 11,654,636 | $ | 7,253,447 | ||||
| Non-prime / prime ratio | 13.8 : 1 | 9.4 : 1 | ||||||
| Commitments to fund loans | $ | 3,244,958 | $ | 2,221,671 | ||||
| Loan sales | $ | 11,631,790 | $ | 7,813,332 | ||||
| Gains on sales of mortgage assets | $ | 424,034 | $ | 320,517 | ||||
Execution price — net gain on sale(3) | 4.18 | % | 4.44 | % | ||||
| (1) | Includes all direct sales and back office sales support associates. | |
| (2) | Percentage of loans funded divided by total applications. | |
| (3) | Defined as total premium received divided by total balance of loans delivered to third party investors or securitization vehicles (excluding mortgage servicing rights and the effect of loan origination expenses). |
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Gains on salesales of mortgage loans and related assets for both wholesale and retail increased $145.5 million to $497.5$103.5 million for the ninesix months ended JanuaryOctober 31, 2003. ThisThe increase over last year is a result of a significant increase in loan production volume. Fororigination volume, partially offset by a decrease in loan sale execution pricing and increased loan origination expenses. During the nine months ended January 31, 2003,current year, the Company originated $11.8$11.7 billion in mortgage loans compared to $8.2$7.3 billion last year, an increase of 44.4%60.7%. The increase in loan production isexecution price on mortgage loans originated and sold decreased to 4.18% for the current period compared to 4.83% last year, primarily as a result of an increase in the number of applications received, an increase in the closing ratio and an increasea decrease in the average loan size. Excludinginterest rate during the $634.0 million of loans acquired and sold, the execution price increased slightly to 4.75% from 4.74% last year. During the period, the Company received 83% of its gain on sale in cash, compared to 80% in the prior year. See further discussion in the Financial Condition section.period.
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Write-downsImpairments of residual interests in securitizations of $25.6$11.1 million were recognized duringin the current period,six months ended October 31, 2003, due to a decline in value of older residuals based on loan performance. Write-downs onImpairments of residuals for the ninesix months ended JanuaryOctober 31, 2002 totaled $29.6$24.1 million.
AccretionThe following table summarizes the key drivers of loan servicing revenues:
| (dollars in 000s) | Six months ended October 31, | |||||||
| 2003 | 2002 | |||||||
| Number of loans serviced | 295,636 | 220,842 | ||||||
| Average servicing portfolio | $ | 34,896,920 | $ | 25,707,639 | ||||
| Average delinquency rate | 6.43 | % | 6.92 | % | ||||
| Value of MSRs | $ | 111,960 | $ | 99,774 | ||||
Loan servicing revenues increased $19.7 million, or 24.5%, this year. The increase reflects a higher loan servicing portfolio. The average servicing portfolio for the six months ended October 31, 2003 increased $9.2 billion, or 35.7%, to $34.9 billion.
Total accretion of residual interests of $43.9$70.9 million for the six months ended October 31, 2003 represents an increasea decrease of $25.9$21.9 million over thefrom prior year accretion of $18.0 million, primarily$92.9 million. This decline is due to added residual interestsa lower average balance of related residuals, resulting primarily from loan sale activity. Accretion of realized gains on residual write-ups of $69.3 million were realized during the nine months ended January 31, 2003, compared to $11.3 million in the prior year. This improvement is the result of increases in the related asset values due to declining interest rates and added residuals from loan sale activity. As a result of the sale of residual interests previously securitized totaling $206.6 millionNIM residuals during the currentthird quarter future accretion income that would have otherwise been realized from these assets will be commensurately lower.
Duringof fiscal year 2003, the Company’s residual interests continued to perform better than expected primarily due to lower interest rates. As a result, the2003.
The Company recorded pretax mark-to-market write-up adjustments,write-ups on its residual interests, which increased the fair value of its residual interests $162.5$78.4 million during the year.period. These write-ups were partially offset by write-downs of $12.6 million and were recorded, net of write-downs of $14.3 million and deferred taxes of $57.3$24.4 million, in other comprehensive income and will be accreted into income throughout the remaining life of those residual interests. Future changes in interest rates or other assumptions, based on market conditions or actual loan pool performance, could cause additional adjustments to the fair value of the residual interests and wouldcould cause changes to the accretion of these residual interests in future periods. Write-upsAdditionally, sales of NIM residual interests of $45.5 million were recorded during the nine months ended January 31, 2002.would result in decreases to accretion income in future periods.
Interest income increased $25.9$14.9 million, to $80.6 million due to a higher average receivable balance fromor 27.4%, for the Trusts and an increase in the interest rate margin to 5.99% during the ninesix months ended JanuaryOctober 31, 2003, compared to 5.36% last year.
Loan servicing revenues increased $23.3 million, or 23.2%, to $123.6 million this year. The increase reflects a higher loan servicing portfolio. The average servicing portfolio for the nine-month period ended January 31, 2003 increased $6.8 billion, or 34.9%, to $26.3 billion.
Total expenses increased $87.3 million, or 32.2%, primarily due to a $54.0 million increase in compensation and benefit costs due to an increase in the numberaverage balance on loans held by the Trusts. This increase was offset by lower interest margin earned. The interest margin decreased to 5.45% during the six months ended October 31, 2003, from 5.85% a year ago.
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Total expenses for the six months ended October 31, 2003, increased $81.9 million, or 36.5% over the year-ago period. This increase is primarily due to a $27.4 million increase in compensation and benefits as a result of employeesa 23.5% increase in sales associates needed to support increasinghigher loan production volumes. Servicing and processing expenses increased by $20.2 million as a result of a higher average servicing portfolio during the six months ended October 31, 2003. Occupancy and equipment charges increased $6.2 million due to nine additional branch offices opened since October 2002, continued expansion of the second servicing center that opened in August 2002 and additional administrative office space. Bad debt expense increased $12.6 million primarily as a result of the increase in whole loan sales compared to securitizations, for which higher reserves are set up at the time of sale for estimated repurchases. Other expenses increased by $28.3$15.4 million to $72.0$65.8 million for the quartercurrent period, primarily due to $4.4 million in increased marketing expenses and $5.9 million in increased allocated corporate and shared costs. Allocated costs increased due to higher insurance costs and the expensing of stock-based compensation.
Pretax income increased $47.3 million to $347.9 million for the six months ended JanuaryOctober 31, 2003.
Business Services
This segment is engaged in providing accounting, tax, consulting, payroll, employee benefits and capital markets services to business clients and tax, financial and estate planning, wealth management and insurance services to individuals. Business Services provides accounting, payroll and human resources services to McGladrey & Pullen LLP (M&P) in exchange for a management fee. The Company also has commitments to fund M&P’s operations.
A substantial portion of Business Services’ business is generated by one-time projects or extended services. Improvements in the current business environment have caused clients to begin cautiously spending money on discretionary projects. Results in the Company’s consulting services remain weak while other service revenues are seeing improvement.
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Business Services — Three-Month Results
| (in 000s) | Three months ended | ||||||||||||
| October 31, 2003 | October 31, 2002 | July 31, 2003 | |||||||||||
| Traditional accounting | $ | 54,441 | $ | 51,195 | $ | 45,096 | |||||||
| Business consulting | 21,174 | 21,755 | 21,575 | ||||||||||
| Capital markets | 17,870 | 10,563 | 16,630 | ||||||||||
| Other | 15,539 | 14,370 | 15,198 | ||||||||||
| Total revenues | 109,024 | 97,883 | 98,499 | ||||||||||
| Compensation and benefits | 75,397 | 65,654 | 70,285 | ||||||||||
| Occupancy and equipment | 6,785 | 6,789 | 6,066 | ||||||||||
| Depreciation and amortization | 5,647 | 5,457 | 5,496 | ||||||||||
| Marketing and advertising | 1,660 | 1,775 | 2,195 | ||||||||||
| Bad debt expense | 1,116 | 2,439 | 1,361 | ||||||||||
| Other | 21,151 | 19,554 | 19,775 | ||||||||||
| Total expenses | 111,756 | 101,668 | 105,178 | ||||||||||
| Pretax loss | $ | (2,732 | ) | $ | (3,785 | ) | $ | (6,679 | ) | ||||
Three months ended October 31, 2003 compared to October 31, 2002
Business Services’ revenues for the three months ended October 31, 2003 increased $11.1 million, or 11.4%, from the prior year. This increase was primarily due to a $4.1$7.3 million increase in depreciation,capital markets revenues, resulting from a $7.8higher number of business valuation projects. Traditional accounting revenues also increased $3.2 million due to more billable hours during the quarter for tax services.
Total expenses increased $10.1 million, or 9.9%, for the three months ended October 31, 2003 compared to the prior year. Compensation and benefits costs increased $9.7 million, primarily as a result of the increased activity in the capital markets business. Additionally, other expenses increased $1.6 million, primarily due to increased employee recruiting costs.
The pretax loss for the three months ended October 31, 2003 was $2.7 million compared to a loss of $3.8 million in the prior year.
Due to the seasonal nature of this segment’s business, operating results for the three months ended October 31, 2003 are not comparable to the three months ended July 31, 2003 and are not indicative of the expected results for the entire fiscal year.
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Business Services — Six-Month Results
| (in 000s) | Six months ended | ||||||||
| October 31, 2003 | October 31, 2002 | ||||||||
| Traditional accounting | $ | 99,537 | $ | 101,117 | |||||
| Business consulting | 42,749 | 43,493 | |||||||
| Capital markets | 34,500 | 20,481 | |||||||
| Other | 30,737 | 28,106 | |||||||
| Total revenues | 207,523 | 193,197 | |||||||
| Compensation and benefits | 145,682 | 134,728 | |||||||
| Occupancy and equipment | 12,851 | 11,291 | |||||||
| Depreciation and amortization | 11,143 | 11,192 | |||||||
| Marketing and advertising | 3,855 | 3,265 | |||||||
| Bad debt expense | 2,477 | 3,328 | |||||||
| Other | 40,926 | 37,451 | |||||||
| Total expenses | 216,934 | 201,255 | |||||||
| Pretax loss | $ | (9,411 | ) | $ | (8,058 | ) | |||
Six months ended October 31, 2003 compared to October 31, 2002
Business Services’ revenues for the six months ended October 31, 2003 increased $14.3 million, or 7.4%, from the prior year. This increase was primarily due to a $14.0 million increase in marketingcapital markets revenues, resulting from a higher number of business valuation projects. Other revenues also increased $2.6 million due to improved performance in the outsourced services area. These increases were partially offset by a slight decline in traditional accounting revenues.
Total expenses and increases in other administrative expenses including legal and consulting costs.
Pretax earnings increased $325.7$15.7 million, to $563.1 millionor 7.8%, for the ninesix months ended JanuaryOctober 31, 2003.2003 compared to the prior year. Compensation and benefits costs increased $11.0 million, primarily as a result of the increased activity in the capital markets business. Additionally, other expenses increased $3.5 million, primarily due to increased recruiting and insurance costs.
The pretax loss for the six months ended October 31, 2003 was $9.4 million compared to a loss of $8.1 million in the prior year.
Investment Services
This segment is primarily engaged in offering investment adviceservices and servicessecurities products through H&R Block Financial Advisors, Inc. (HRBFA), a full-service securities broker-dealer. HRBFA isbroker-dealer and a member of the New York Stock Exchange and other principal exchanges. The Investment
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Services segment offersregistered investment planning, brokerage services, investment advice, and related financial services and securities products through approximately 1,700 financial advisors at approximately 715 branch offices located throughout the United States. Some offices are co-located with tax and mortgage offices to offer customers one location for their tax and financial services needs.
advisor. Products and services offered to Investment Services’ customers include: stock trading,equities, annuities, fixed income products, mutual funds, margin accounts, money market funds with sweep provisions for settlement of customer transactions, checking privileges, account access/review via the internet, online trading, fee-based accounts, individual retirement accounts, dividend reinvestment and option accounts, and stockequity research and recommendations.focus lists, model portfolios, asset allocation strategies, economic commentaries and other investment tools and information. In addition, clients of the Company’s U.S. Tax Operations segment are given the opportunity to open an individual retirement account (Express IRA)Express IRA through HRBFA as a part of the income tax return preparation process. The Express IRA is invested in an FDIC insured money market account through Reserve Management Corporation at a federally insured depository institution paying competitive money market interest rates.
Investment Services — Three-Month Operating Statistics(actual amounts, except as indicated)
| Three months ended | ||||||||||||
| January 31, | January 31, | October 31, | ||||||||||
| 2003 | 2002 | 2002 | ||||||||||
| Customer trades | 306,119 | 402,016 | 292,880 | |||||||||
| Customer daily average trades | 4,638 | 6,241 | 4,576 | |||||||||
| Average revenue per trade | $ | 115.57 | $ | 100.53 | $ | 119.21 | ||||||
| Number of active accounts | 670,000 | 603,000 | 710,000 | |||||||||
| Average trades per active account per quarter | 0.46 | 0.67 | 0.41 | |||||||||
| Average trades per active account per year (annualized) | 1.83 | 2.67 | 1.65 | |||||||||
| Ending balance of assets under administration (billions) | $ | 21.0 | $ | 27.2 | $ | 21.4 | ||||||
| Average assets per active account | $ | 31,397 | $ | 45,191 | $ | 30,102 | ||||||
| Ending margin balances (000s) | $ | 535,000 | $ | 878,000 | $ | 503,000 | ||||||
| Ending customer payables balances (000s) | $ | 802,000 | $ | 865,000 | $ | 821,000 | ||||||
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Investment Services — Three-Month Operating Results
| Three months ended | |||||||||||||
| January 31, | January 31, | October 31, | |||||||||||
| 2003 | 2002 | 2002 | |||||||||||
| Margin interest revenue | $ | 8,887 | $ | 13,740 | $ | 9,758 | |||||||
| Less: interest expense | 945 | 2,095 | 1,586 | ||||||||||
| Net interest income | 7,942 | 11,645 | 8,172 | ||||||||||
| Commission revenue | 21,743 | 26,859 | 20,187 | ||||||||||
| Fee revenue | 8,097 | 6,451 | 8,039 | ||||||||||
| Firm trading revenue | 10,557 | 10,191 | 11,509 | ||||||||||
| Other | (1,237 | ) | 3,844 | 534 | |||||||||
| Total revenues (1) | 47,102 | 58,990 | 48,441 | ||||||||||
| Commissions | 10,521 | 11,392 | 9,740 | ||||||||||
| Other variable expenses | 1,332 | 2,238 | 831 | ||||||||||
| Total variable expenses | 11,853 | 13,630 | 10,571 | ||||||||||
| Operating margin | 35,249 | 45,360 | 37,870 | ||||||||||
| Compensation and benefits | 22,110 | 22,603 | 23,360 | ||||||||||
| Occupancy and equipment | 8,384 | 5,903 | 6,640 | ||||||||||
| Depreciation and amortization | 6,680 | 5,314 | 5,621 | ||||||||||
| Amortization of acquisition intangibles | 7,325 | 7,362 | 7,325 | ||||||||||
| Impairment of goodwill | — | — | 6,000 | ||||||||||
| Other | 17,906 | 10,947 | 13,929 | ||||||||||
| Allocated corporate and shared costs | 4,599 | 5,531 | 2,931 | ||||||||||
| Total fixed expenses | 67,004 | 57,660 | 65,806 | ||||||||||
| Pretax loss | $ | (31,755 | ) | $ | (12,300 | ) | $ | (27,936 | ) | ||||
Three months ended January 31, 2003 compared to January 31, 2002
Investment Services’ revenues, net of interest expense, for the three months ended January 31, 2003 declined $11.9 million, or 20.2%, to $47.1 million compared to the prior year. The decrease is primarily due to lower net interest income and commission revenue.
Margin interest revenue declined 35.3% to $8.9 million from the prior year, which is primarily a result of a 39.0% decline in margin balances and, to a lesser extent, lower interest rates. Margin balances have declined from an average of $863.0 million for the three months ended January 31, 2002 to $515.0 million in the current period, due to weak investor confidence and declining stock market values. Accordingly, interest expense for the third quarter of fiscal year 2003 declined 54.9% to $0.9 million compared to $2.1 million in the third quarter of fiscal year 2002.
The Company measures the profitability of margin lending activities through the net interest margin. Net interest margin is defined as interest earned on the average margin loan balance, less the cost of funding these loans. Net interest margin declined from 0.58% for the quarter ended
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January 31, 2002 to .41% for the quarter ended January 31, 2003, in conjunction with the decrease in market rates.
Commission revenue declined $5.1 million, or 19.0%, to $21.7 million. Total customer trades for the current quarter were 306 thousand, a decline of 23.9% from 402 thousand trades in the prior year. Customer trading has continued to decline as a result of weak investor confidence and declining stock market values.
Fee revenue increased $1.6 million, or 25.5%, due to the implementation of a new fee structure in November of last year, and the addition of wealth management products. Wealth management products accounted for $1.2 million of the total increase in fee revenues.
Firm trading revenue, including equities, fixed income trading, underwriting, and unit investment trusts, increased 3.6% to $10.6 million. Underwriting revenues increased $2.7 million, or 84.8%, to $5.8 million from $3.1 million in the third quarter of fiscal year 2002, primarily due to increased demand for Trust Preferred Debt Securities and additional underwriting fees in the current year quarter. Partially offsetting these increases, revenues from fixed income trading decreased 15.4% to $4.4 million from $5.2 million. Equity trading declined $1.3 million as a result of the principal equity trading operations closing in April 2002.
Other revenues declined from the prior year due to losses incurred on the disposition of certain assets.
Total expenses increased $7.6 million, or 10.6%, to $78.9 million primarily as a result of increases in operating expenses resulting from various new initiatives to expand products and the business, including the installation of a new back office brokerage operating system and relocation to new offices. These increased expenses were partially offset by a decrease in commissions expense due to the decline in customer trading and cost containment measures.
The pretax loss for Investment Services for the third quarter of fiscal year 2003 was $31.8 million compared to the prior year loss of $12.3 million.
As a result of meeting certain three-year production goals established in connection with the acquisition of OLDE Discount Corporation, certain long-term advisors were eligible to receive a one-time retention payment. The retention period was through December 31, 2002, and retention payments under this plan of approximately $17.0 million were accrued in prior periods and made in February 2003.
Three months ended January 31, 2003 compared to October 31, 2002
Investment Services’ revenues, net of interest expense, for the three months ended January 31, 2003 declined $1.3 million, or 2.8%, to $47.1 million compared to the preceding quarter.
Margin interest revenue declined $0.9 million, or 8.9%, to $8.9 million for the quarter ended January 31, 2003. Decreasing margin interest revenue is due primarily to lower customer margin balances, which have declined 8.0% from an average of $560.0 million for the second quarter of 2003 to an average of $515.0 million for the third quarter. Corresponding decreases in margin
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interest expense resulted in net interest in the third quarter that was comparable with net interest in the preceding quarter.
Commission revenue increased $1.6 million, or 7.7%, to $21.7 million, as a result of a 4.5% increase in total customer trades to 306 thousand for the third quarter, compared to 293 thousand in the second quarter.
Firm trading revenue, including equities, fixed income trading, underwriting, and unit investment trusts, decreased 8.3% from the second quarter of fiscal year 2003 to $10.6 million in the third quarter. This decrease was primarily due to a decline in underwriting revenues, partially offset by higher municipal bond trading revenue.
Total expenses increased $2.5 million from the preceding quarter. Increased expenses were primarily due to costs relating to the installation of a new back office brokerage operating system and relocation costs, partially offset by the $6.0 million goodwill impairment charge recorded during the second quarter.
The third-quarter pretax loss for the Investment Services segment increased 13.7% to $31.8 million from $27.9 million in the second quarter of fiscal year 2003.
Investment Services — Nine-Month Operating Statistics(actual amounts, except as indicated)
| Nine months ended | ||||||||
| January 31, | January 31, | |||||||
| 2003 | 2002 | |||||||
| Customer trades | 973,249 | 1,168,453 | ||||||
| Customer daily average trades | 5,043 | 6,215 | ||||||
| Average revenue per trade | $ | 117.95 | $ | 105.25 | ||||
| Number of active accounts | 670,000 | 603,000 | ||||||
| Ending balance of assets under administration (billions) | $ | 21.0 | $ | 27.2 | ||||
| Average assets per active account | $ | 31,397 | $ | 45,191 | ||||
| Ending margin balances (000s) | $ | 535,000 | $ | 878,000 | ||||
| Ending customer payables balances (000s) | $ | 802,000 | $ | 865,000 | ||||
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Investment Services — Nine-Month Operating Results
| Nine months ended | |||||||||
| January 31, | January 31, | ||||||||
| 2003 | 2002 | ||||||||
| Margin interest revenue | $ | 29,841 | $ | 55,564 | |||||
| Less: interest expense | 4,222 | 13,007 | |||||||
| Net interest income | 25,619 | 42,557 | |||||||
| Commission revenue | 67,284 | 79,373 | |||||||
| Fee revenue | 24,745 | 17,762 | |||||||
| Firm trading revenue | 35,018 | 34,349 | |||||||
| Other | (151 | ) | 7,789 | ||||||
| Total revenues (1) | 152,515 | 181,830 | |||||||
| Commissions | 31,641 | 36,162 | |||||||
| Other variable expenses | 2,711 | 7,297 | |||||||
| Total variable expenses | 34,352 | 43,459 | |||||||
| Operating margin | 118,163 | 138,371 | |||||||
| Compensation and benefits | 69,321 | 63,224 | |||||||
| Occupancy and equipment | 21,646 | 21,004 | |||||||
| Depreciation and amortization | 17,677 | 15,099 | |||||||
| Amortization of acquisition intangibles | 21,975 | 22,124 | |||||||
| Impairment of goodwill | 24,000 | — | |||||||
| Other | 45,534 | 35,125 | |||||||
| Allocated corporate and shared costs | 10,498 | 9,328 | |||||||
| Total fixed expenses | 210,651 | 165,904 | |||||||
| Pretax loss | $ | (92,488 | ) | $ | (27,533 | ) | |||
Nine months ended January 31, 2003 compared to January 31, 2002
Investment Services’ revenues, net of interest expense, declined $29.3 million, or 16.1%, to $152.5 million for the nine months ended January 31, 2003 compared to the prior year. Revenues have declined due to difficult market conditions resulting in lower net interest income and commission revenue.
Margin interest revenue declined 46.3%, down to $29.8 million from the prior year as a result of declining margin balances and, to a lesser extent, lower interest rates. Margin balances declined from an average of $1.1 billion for the nine months ended January 31, 2002, to $598.7 million in the current period. Total interest expense decreased 67.5% to $4.2 million compared to the nine months ended January 31, 2002. Net interest margin declined from 1.06% for the nine months ended January 31, 2002 to .49% for the current year, in conjunction with the decrease in market rates.
Commission revenue declined $12.1 million, or 15.2%, to $67.3 million. Commission revenue decreased as a result of a 16.7% decline in total customer trades from 1.2 million trades in the
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previous year to 973 thousand trades for the nine months ended January 31, 2003. This decline was partially offset by an increase in average revenue per trade.
Fee revenue increased $7.0 million, or 39.3%, due to the implementation of a new fee structure in November of last year, and the addition of wealth management products.
During the first quarter of fiscal year 2003, the Company engaged an independent valuation firm to evaluate the fair value of goodwill related to the Investment Services segment as of July 31, 2002. An estimated impairment charge of $18.0 million was recorded during the first quarter of fiscal year 2003, and an additional impairment charge of $6.0 million was recorded during the second quarter. No goodwill impairment charges were identified during the nine months ended January 31, 2002.
Total expenses increased $35.6 million, or 17.0%, to $245.0 million, due primarily to the $24.0 million goodwill impairment charge recorded in the current year. The remaining increase in operating expenses was due to various new initiatives to expand products and the business, including the installation of a new back office brokerage operating system. These increased expenses were partially offset by a decrease in commissions expense due to the decline in customer trading.
Key to the future success of the Investment Services segment is retention of its financial advisors and recruitment of new advisors. One of the Company’s key initiatives this year is to build revenues through the addition of experienced financial advisors. More than 100 new advisors tohave been recruited through the organization. During the thirdsecond quarter, 122which was offset by attrition of primarily less experienced advisors. The retention and recruitment of experienced advisors were added, bringing the total hired thiscontinues to be a key initiative for fiscal year 2004.
Investment Services — Three-Month Statistics
| Three months ended | |||||||||||||
| October 31, 2003 | October 31, 2002 | July 31, 2003 | |||||||||||
| Customer trades (1) | 347,828 | 292,880 | 363,053 | ||||||||||
| Customer daily average trades | 5,351 | 4,576 | 5,339 | ||||||||||
| Average revenue per trade (2) | $ | 116.22 | $ | 119.21 | $ | 126.46 | |||||||
| Number of active accounts | 748,403 | 710,495 | 755,643 | ||||||||||
| Average trades per active account per quarter | 0.46 | 0.41 | 0. 48 | ||||||||||
| Average trades per active account per year (annualized) | 1.86 | 1.65 | 1.92 | ||||||||||
| Ending balance of assets under administration (billions) | $ | 25.7 | $ | 21.4 | $ | 24.3 | |||||||
| Average assets per active account | $ | 34,340 | $ | 30,102 | $ | 32,114 | |||||||
| Ending margin balances (millions) | $ | 538 | $ | 503 | $ | 517 | |||||||
| Ending customer payables balances (millions) | $ | 981 | $ | 821 | $ | 923 | |||||||
| Number of advisors | 1,010 | 1,055 | 1,001 | ||||||||||
| Included in the numbers above are the following relating to fee-based accounts: | |||||||||||||
| Customer accounts | 5,174 | 4,351 | 4,894 | ||||||||||
| Average revenue per account | $ | 1,897 | $ | 1,505 | $ | 1,701 | |||||||
| Ending balance of assets under administration (millions) | $ | 1,088 | $ | 658 | $ | 916 | |||||||
| Average assets per active account | $ | 210,290 | $ | 151,170 | $ | 187,064 | |||||||
| (1) | Includes both trades on which commissions are earned (“commissionable trades”) and trades for which no commission is earned (“fee-based trades”). Excludes open-ended mutual fund redemptions. | |
| (2) | Calculated as total commissions divided by commissionable trades. |
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Investment Services — Three-Month Results
| (in 000s) | Three months ended | ||||||||||||||||||||
| October 31, 2003 | October 31, 2002 | July 31, 2003 | |||||||||||||||||||
| Transactional revenue | $ | 23,162 | $ | 22,906 | $ | 25,985 | |||||||||||||||
| Annuitized revenue | 13,689 | 8,029 | 12,476 | ||||||||||||||||||
| Production revenue | 36,851 | 30,935 | 38,461 | ||||||||||||||||||
| Other revenue | 7,795 | 9,334 | 9,996 | ||||||||||||||||||
| Non-interest revenue | 44,646 | 40,269 | 48,457 | ||||||||||||||||||
| Margin interest revenue | 8,057 | 9,758 | 8,530 | ||||||||||||||||||
| Less: interest expense | 207 | 1,586 | 610 | ||||||||||||||||||
| Net interest revenue | 7,850 | 8,172 | 7,920 | ||||||||||||||||||
| Total revenues (1) | 52,496 | 48,441 | 56,377 | ||||||||||||||||||
| Commissions | 10,875 | 9,740 | 12,441 | ||||||||||||||||||
| Other variable expenses | 1,403 | 831 | 1,201 | ||||||||||||||||||
| Total variable expenses | 12,278 | 10,571 | 13,642 | ||||||||||||||||||
| Gross profit | 40,218 | 37,870 | 42,735 | ||||||||||||||||||
| Compensation and benefits | 22,751 | 23,360 | 22,430 | ||||||||||||||||||
| Occupancy and equipment | 6,823 | 6,640 | 7,221 | ||||||||||||||||||
| Depreciation and amortization | 11,046 | 12,946 | 11,591 | ||||||||||||||||||
| Impairment of goodwill | — | 6,000 | — | ||||||||||||||||||
| Other | 10,223 | 13,929 | 11,469 | ||||||||||||||||||
| Allocated corporate and shared costs | 4,711 | 2,931 | 3,781 | ||||||||||||||||||
| Total fixed expenses | 55,554 | 65,806 | 56,492 | ||||||||||||||||||
| Pretax loss | $ | (15,336 | ) | $ | (27,936 | ) | $ | (13,757 | ) | ||||||||||||
| (1) | Total revenues, less interest expense. |
Three months ended October 31, 2003 compared to 247, versusOctober 31, 2002
Investment Services’ revenues, net of interest expense, for the three months ended October 31, 2003 increased $4.1 million, or 8.4%, to $52.5 million compared to prior year revenues of $48.4 million. The increase is primarily due to higher annuitized revenues, which are based on customer assets rather than transactions.
Transactional revenue, which is based on transaction or trade quantities, rose $0.3 million, or 1.1%, from the prior year due to an increase in trading activity, partially offset by a decline in the average revenue per trade. Annuitized revenues increased $5.7 million, or 70.5%, due to increased sales of annuities and mutual funds.
Margin interest revenue declined 17.4% from the prior year to $8.1 million, which is primarily a result of a 13.4% decline in interest rates and an 8.1% decrease in average margin balances. Margin balances have declined from an average of $560.0 million for the three months ended October 31, 2002 to $514.4 million in the current period, due to weak investor confidence.
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Interest expense for the second quarter of fiscal year goal2004 declined 87.0% to $0.2 million compared to $1.6 million in the second quarter of 250. While revenues continuefiscal year 2003.
Total expenses decreased $8.5 million, or 11.2%, to build$67.8 million primarily as a result of this initiative, revenues generated by newly recruited advisors have grown slower than anticipated given the current market environment.$6.0 million goodwill impairment charge recorded in the prior year. Other expenses decreased primarily as a result of consulting fees incurred in the prior year related to the conversion to a new back-office system.
The pretax loss for Investment Services for the nine months ended January 31, 2003second quarter of fiscal year 2004 was $92.5$15.3 million compared to the prior periodyear loss of $27.9 million.
Three months ended October 31, 2003 compared to July 31, 2003
Investment Services’ revenues, net of interest expense, for the three months ended October 31, 2003 declined $3.9 million, or 6.9%, to $52.5 million compared to the preceding quarter.
Production revenue decreased $1.6 million, or 4.2%, primarily due to the continued shift to fee-based products.
Margin interest revenue fell $0.5 million, or 5.5%, to $8.1 million for the quarter ended October 31, 2003, which is primarily a result of lower interest rates.
Total expenses decreased $2.3 million from the preceding quarter. The $1.6 million decrease in commission expense is primarily due to the decline in production revenues. In addition, other expenses declined $1.2 million primarily as a result of first quarter postage costs related to customer mailings.
The pretax loss for the Investment Services segment was $15.3 million, compared to a loss of $27.5$13.8 million in the first quarter of fiscal year 2004.
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Investment Services — Six-Month Statistics
| Six months ended | ||||||||
| October 31, 2003 | October 31, 2002 | |||||||
Customer trades(1) | 710,881 | 667,130 | ||||||
| Customer daily average trades | 5,345 | 5,253 | ||||||
Average revenue per trade(2) | $ | 121.44 | $ | 119.04 | ||||
| Number of active accounts | 748,403 | 710,495 | ||||||
| Ending balance of assets under administration (billions) | $ | 25.7 | $ | 21.4 | ||||
| Average assets per active account | $ | 34,340 | $ | 30,102 | ||||
| Ending margin balances (millions) | $ | 538 | $ | 503 | ||||
| Ending customer payables balances (millions) | $ | 981 | $ | 821 | ||||
| Number of advisors | 1,010 | 1,055 | ||||||
| Included in the numbers above are the following relating to fee-based accounts: | |||||||||
| Customer accounts | 5,174 | 4,351 | |||||||
| Average revenue per account | $ | 1,753 | $ | 1,484 | |||||
| Ending balance of assets under administration (millions) | $ | 1,088 | $ | 658 | |||||
| Average assets per active account | $ | 210,290 | $ | 151,170 | |||||
| (1) | Includes both trades on which commissions are earned (“commissionable trades”) and trades for which no commission is earned (“fee-based trades”). Excludes open-ended mutual fund redemptions. | |
| (2) | Calculated as total commissions divided by commissionable trades. |
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Investment Services — Six-Month Results
| (in 000s) | Six months ended | |||||||||
| October 31, 2003 | October 31, 2002 | |||||||||
| Transactional revenue | $ | 49,147 | $ | 51,865 | ||||||
| Annuitized revenue | 26,165 | 17,368 | ||||||||
| Production revenue | 75,312 | 69,233 | ||||||||
| Other revenue | 17,791 | 18,503 | ||||||||
| Non-interest revenue | 93,103 | 87,736 | ||||||||
| Margin interest revenue | 16,587 | 20,954 | ||||||||
| Less: interest expense | 817 | 3,277 | ||||||||
| Net interest revenue | 15,770 | 17,677 | ||||||||
Total revenues(1) | 108,873 | 105,413 | ||||||||
| Commissions | 23,316 | 21,120 | ||||||||
| Other variable expenses | 2,604 | 1,379 | ||||||||
| Total variable expenses | 25,920 | 22,499 | ||||||||
| Gross profit | 82,953 | 82,914 | ||||||||
| Compensation and benefits | 45,181 | 47,211 | ||||||||
| Occupancy and equipment | 14,044 | 13,262 | ||||||||
| Depreciation and amortization | 22,637 | 25,647 | ||||||||
| Impairment of goodwill | — | 24,000 | ||||||||
| Other | 21,692 | 27,628 | ||||||||
| Allocated corporate and shared costs | 8,492 | 5,899 | ||||||||
| Total fixed expenses | 112,046 | 143,647 | ||||||||
| Pretax loss | $ | (29,093 | ) | $ | (60,733 | ) | ||||
| (1) | Total revenues, less interest expense. |
Six months ended October 31, 2003 compared to October 31, 2002
Investment Services’ revenues, net of interest expense, for the six months ended October 31, 2003 improved $3.5 million, or 3.3%, to $108.9 million compared to prior year revenues of $105.4 million. Operating resultsThe increase is primarily due to higher annuitized revenue.
Transactional revenue declined $2.7 million, or 5.2%, from the prior year due to the continued shift to fee-based products. Annuitized revenues increased $8.8 million, or 50.7%, due to increased sales of annuities and mutual funds.
Margin interest revenue declined 20.8% from the prior year to $16.6 million, which is primarily a result of lower margin balances. Margin balances have declined from an average of $640.0 million for the six months ended October 31, 2002 to $507.7 million in the current period. Interest expense for the first half of fiscal year 2004 declined 75.1% to $0.8 million compared to $3.3 million in the first half of fiscal year 2003.
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Total expenses decreased $28.2 million, or 17.0%, to $138.0 million primarily as a result of the $24.0 million goodwill impairment charge recorded in the prior year. Other expenses decreased $5.9 million primarily as a result of consulting fees incurred in the prior year related to the conversion to a new back-office system. Depreciation and amortization declined by $3.0 million as a result of the consolidation of field offices and the related asset sales. Commissions and other variable expenses increased as a result of higher production revenues.
The pretax loss for Investment Services have declined primarily duefor the first half of fiscal year 2004 was $29.1 million compared to weak trading activity, a decline in margin lending and goodwill impairment charges. Revenues are closely linked with the overall performanceprior year loss of market indices and operating results are not likely to improve substantially until investor confidence strengthens and market conditions improve.$60.7 million.
Business ServicesInternational Tax Operations
This segment is primarily engaged in providing accounting,local tax consulting, payroll, employee benefitsreturn preparation, filing and capital marketsrelated services to business clients and tax and financial planning, wealth management and insurance services to individuals.
To expand its service offerings, the Company acquired a controlling interest in MyBenefitSource, Inc. (MBS), an integrated payroll and benefits processing company, and 100% of Equico Resources, LLC (Equico), a valuation, merger and acquisition-consulting firm, in December 2001. These acquisitions were accounted for as purchases,Canada, Australia and the resultsUnited Kingdom. In addition, International Tax Operations includes Overseas operations, which consists of operationscompany-owned and franchise offices in eight countries that prepare U.S. tax returns for these businesses have been consolidated inU.S. citizens living abroad. This segment financial results since the date of acquisition. Segment revenues have increasedserved 2.3 million taxpayers in fiscal year 2003 compared2003.
Tax-related service revenues include fees from company-owned tax offices and royalties from franchise offices. The Canadian tax season is from January to fiscal year 2002 as a resultApril, the Australian tax season is from July to October and the United Kingdom’s tax season is from August to March.
Operations in this segment of the Company are transacted in the local currencies of the countries in which it operates, therefore the results can be affected by the translation into U.S. dollars. The weakening of the U.S. dollar during the quarter had the impact of increasing reported revenues, income and losses.
-44-International Tax Operations — Three-Month Results
| (in 000s) | Three months ended | |||||||||||||
| October 31, 2003 | October 31, 2002 | July 31, 2003 | ||||||||||||
| Revenues: | ||||||||||||||
| Canada | $ | 3,025 | $ | 2,529 | $ | 3,766 | ||||||||
| Australia | 15,657 | 12,345 | 1,123 | |||||||||||
| United Kingdom | 305 | 329 | 319 | |||||||||||
| Overseas | 108 | 123 | 251 | |||||||||||
| Total revenues | 19,095 | 15,326 | 5,459 | |||||||||||
| Pretax income (loss): | ||||||||||||||
| Canada | (4,858 | ) | (4,260 | ) | (3,695 | ) | ||||||||
| Australia | 6,297 | 5,030 | (2,010 | ) | ||||||||||
| United Kingdom | (196 | ) | (193 | ) | (189 | ) | ||||||||
| Overseas | (127 | ) | (359 | ) | (78 | ) | ||||||||
| Allocated corporate and shared costs | (561 | ) | (468 | ) | (436 | ) | ||||||||
| Pretax income (loss) | $ | 555 | $ | (250 | ) | $ | (6,408 | ) | ||||||
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these acquisitions. In addition, both MBS and Equico are start-up businesses and are currently generating operating losses that have adversely impacted fiscal year 2003 segment results.
Business Services — Three-Month Results
| Three months ended | |||||||||||||
| January 31, | January 31, | October 31, | |||||||||||
| 2003 | 2002 | 2002 | |||||||||||
| Accounting, consulting and tax | $ | 88,817 | $ | 92,651 | $ | 85,000 | |||||||
| Product sales | 4,871 | 4,742 | 5,774 | ||||||||||
| Management fee revenue | 3,150 | 3,150 | 3,150 | ||||||||||
| Other | 3,903 | 6,518 | 3,959 | ||||||||||
| Total revenues | 100,741 | 107,061 | 97,883 | ||||||||||
| Compensation and benefits | 65,060 | 64,311 | 65,654 | ||||||||||
| Occupancy and equipment | 7,110 | 4,426 | 6,789 | ||||||||||
| Depreciation and amortization | 2,020 | 1,626 | 1,767 | ||||||||||
| Marketing and advertising | 3,599 | 1,249 | 1,775 | ||||||||||
| Bad debt expense | 3,009 | 3,457 | 2,439 | ||||||||||
| Amortization of acquisition intangibles | 3,754 | 3,569 | 3,690 | ||||||||||
| Other | 19,778 | 26,032 | 19,070 | ||||||||||
| Allocated corporate and shared costs | 608 | 611 | 484 | ||||||||||
| Total expenses | 104,938 | 105,281 | 101,668 | ||||||||||
| Pretax earnings (loss) | $ | (4,197 | ) | $ | 1,780 | $ | (3,785 | ) | |||||
Three months ended JanuaryOctober 31, 2003 compared to JanuaryOctober 31, 2002
Business Services’International Tax Operations’ revenues of $100.7 million for the three months ended JanuaryOctober 31, 2003 declined $6.3increased $3.8 million, or 5.9%24.6%, from the prior year. This decrease was primarily duecompared to a decline of $14.5 million in tax consulting revenues. The current economic recession and a continuing cautious business environment have contributed to weakness in the segment’s business consulting services. This decline was somewhat offset by the acquisition of MBS and Equico, which increased revenue for the current quarter $6.7 million. Revenues also increased $2.1 million over the year ago quarter as a result of growth in outsourcing services.
Total expenses of $104.9 million for the three months ended JanuaryOctober 31, 2003 were comparable2002. This improvement is primarily due to results in Australia, where tax returns prepared in the current quarter increased 3.2% compared to the prior year. Occupancy and equipment costsAdditionally, the average charge per return increased $2.71.3%.
Pretax income of $0.6 million and marketing and advertising costs increased $2.4 million primarily as a result of acquired businesses. These increases were offset by a decline in out-of-pocket expenses billed to clients and other cost reductions.
The pretax loss for the three monthsquarter ended JanuaryOctober 31, 2003, was $4.2an improvement of $0.8 million compared to pretax earnings of $1.8 millionthe loss recorded in 2002.the second quarter last year. This improvement is due primarily to strong performance in the Australian tax season. This improvement was partially offset by unfavorable exchange rates in Canada.
Due to the seasonal nature of this segment’s business, operating results for the three months ended JanuaryOctober 31, 2003 are not comparable to the three months ended OctoberJuly 31, 2002.
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2003 and are not indicative of the expected results for the entire fiscal year.
Business ServicesInternational Tax Operations — Nine-MonthSix-Month Results
| Nine months ended | |||||||||
| January 31, | January 31, | ||||||||
| 2003 | 2002 | ||||||||
| Accounting, consulting and tax | $ | 256,733 | $ | 237,656 | |||||
| Product sales | 16,218 | 15,057 | |||||||
| Management fee revenue | 9,450 | 8,550 | |||||||
| Other | 11,537 | 18,603 | |||||||
| Total revenues | 293,938 | 279,866 | |||||||
| Compensation and benefits | 199,788 | 184,970 | |||||||
| Occupancy and equipment | 18,401 | 14,336 | |||||||
| Depreciation and amortization | 5,528 | 5,249 | |||||||
| Marketing and advertising | 6,864 | 3,919 | |||||||
| Bad debt expense | 6,337 | 8,085 | |||||||
| Amortization of acquisition intangibles | 11,438 | 10,020 | |||||||
| Other | 56,192 | 49,776 | |||||||
| Allocated corporate and shared costs | 1,645 | 1,348 | |||||||
| Total expenses | 306,193 | 277,703 | |||||||
| Pretax earnings (loss) | $ | (12,255 | ) | $ | 2,163 | ||||
| (in 000s) | Six months ended | |||||||||
| October 31, 2003 | October 31, 2002 | |||||||||
| Revenues: | ||||||||||
| Canada | $ | 6,791 | $ | 5,334 | ||||||
| Australia | 16,780 | 13,237 | ||||||||
| United Kingdom | 624 | 642 | ||||||||
| Overseas | 359 | 396 | ||||||||
| Total revenues | 24,554 | 19,609 | ||||||||
| Pretax income (loss): | ||||||||||
| Canada | (8,553 | ) | (8,490 | ) | ||||||
| Australia | 4,287 | 3,451 | ||||||||
| United Kingdom | (385 | ) | (331 | ) | ||||||
| Overseas | (205 | ) | (456 | ) | ||||||
| Allocated corporate and shared costs | (997 | ) | (875 | ) | ||||||
| Pretax income (loss) | $ | (5,853 | ) | $ | (6,701 | ) | ||||
NineSix months ended JanuaryOctober 31, 2003 compared to JanuaryOctober 31, 2002
Business Services’International Tax Operations’ revenues of $293.9 million for the ninesix months ended JanuaryOctober 31, 2003 increased $14.1$4.9 million, or 5.0%25.2%, fromcompared to the prior year. As a result of the acquisitions of MBS and Equico in December 2001, revenues for the nine-month period ended January 31, 2003 increased $28.9 million over the comparable period in 2002. These increases were partially offset by a $13.6 million decline in tax consulting revenues and a $5.2 million decline in insurance product revenues.
Total expenses increased $28.5 million to $306.2 million for the ninesix months ended JanuaryOctober 31, 20032002. This improvement is primarily due to operating expensesresults in Australia, where tax returns prepared in the current period increased 3.5% compared to the prior year and the average charge per return increased 1.4%. Canadian revenues also improved, due to increases of acquired businesses.6.1% in both the number of off-season returns and average charge per return.
The pretax loss of $5.9 million for the ninesix months ended JanuaryOctober 31, 2003, was $12.3 million, a declinean improvement of $14.5$0.8 million compared to prior year earnings of $2.2 million. The pretaxthe loss in 2003 was primarily attributable to losses for MBS and Equico which, in the aggregate, were $14.6 million greater than operating lossesrecorded in the prior year. Results in Australia improved as a result of better performance in the Australian tax season.
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Corporate Operations
This segment consists primarily of corporate support departments, which provide services to the Company’s operating segments. These support departments consist of marketing, information technology, facilities, human resources, supply, executive, legal, finance, government relations and corporate communications. These support department costs are largely allocated to the Company’s operating segments. The Company’s captive insurance and franchise financing subsidiaries are also included within this segment.
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Corporate Operations &Interest Expense on Acquisition Debt — Three-Month Results
| Three months ended | |||||||||||||
| January 31, | January 31, | October 31, | |||||||||||
| 2003 | 2002 | 2002 | |||||||||||
| Operating revenues | $ | 1,846 | $ | 6,950 | $ | 1,553 | |||||||
| Eliminations | (1,551 | ) | (1,166 | ) | (1,410 | ) | |||||||
| Total revenues | 295 | 5,784 | 143 | ||||||||||
| Corporate expenses: | |||||||||||||
| Compensation and benefits | 2,631 | (63 | ) | 4,476 | |||||||||
| Interest expense (1) | 4,283 | 6,656 | 1,299 | ||||||||||
| Marketing and advertising | 1,865 | 10,319 | 83 | ||||||||||
| Other | 6,710 | 1,072 | 5,353 | ||||||||||
| 15,489 | 17,984 | 11,211 | |||||||||||
| Support departments: | |||||||||||||
| Information technology | 24,987 | 23,418 | 22,348 | ||||||||||
| Marketing | 39,488 | 35,442 | 6,069 | ||||||||||
| Finance | 7,530 | 4,908 | 7,293 | ||||||||||
| Other | 24,741 | 20,034 | 13,483 | ||||||||||
| 96,746 | 83,802 | 49,193 | |||||||||||
| Allocation of shared services | (98,163 | ) | (77,607 | ) | (46,436 | ) | |||||||
| Investment income, net | (191 | ) | 467 | 533 | |||||||||
| Pretax loss | $ | (13,968 | ) | $ | (17,928 | ) | $ | (13,292 | ) | ||||
| Interest expense on acquisition debt | $ | 18,014 | $ | 19,243 | $ | 18,203 | |||||||
| (in 000s) | Three months ended | |||||||||||||
| October 31, 2003 | October 31, 2002 | July 31, 2003 | ||||||||||||
| Operating revenues | $ | 2,253 | $ | 1,553 | $ | 2,728 | ||||||||
| Eliminations | (1,565 | ) | (1,410 | ) | (1,400 | ) | ||||||||
| Total revenues | 688 | 143 | 1,328 | |||||||||||
| Corporate expenses: | ||||||||||||||
| Compensation and benefits | 930 | 4,476 | 3,069 | |||||||||||
| Interest expense: | ||||||||||||||
| Interest on acquisition debt | 17,074 | 18,203 | 17,672 | |||||||||||
| Other interest | 89 | 1,299 | 175 | |||||||||||
| Marketing and advertising | (2 | ) | 83 | (76 | ) | |||||||||
| Other | 2,869 | 5,353 | 6,845 | |||||||||||
| 20,960 | 29,414 | 27,685 | ||||||||||||
| Support departments: | ||||||||||||||
| Information technology | 26,738 | 22,348 | 23,213 | |||||||||||
| Marketing | 5,430 | 6,069 | 2,664 | |||||||||||
| Finance | 8,835 | 7,293 | 6,899 | |||||||||||
| Stock-based compensation | 3,084 | — | 1,040 | |||||||||||
| Other | 14,108 | 13,483 | 9,783 | |||||||||||
| 58,195 | 49,193 | 43,599 | ||||||||||||
| Allocation of corporate and shared costs | (58,021 | ) | (46,436 | ) | (43,777 | ) | ||||||||
| Investment income, net | 2,005 | 533 | 1,195 | |||||||||||
| Pretax loss | $ | (18,441 | ) | $ | (31,495 | ) | $ | (24,984 | ) | |||||
Three months ended JanuaryOctober 31, 2003 compared to JanuaryOctober 31, 2002
Revenues declined $5.5 million as a result of $3.4 million in additional allocations to other segments of revenues from supply sales to franchisesCompensation and a $1.6 million decrease in operating investment income.
Corporate expenses declined $2.5 million, or 13.9%, primarily due to lower interest and marketing expenses. Interest expense declined as a result of lower commercial paper borrowings in association with the RAL waiver agreement, while marketing expenses declined as a result of costs which are now charged directly to other segments. Other expenses increased as a result of additional consulting fees of $1.9 million, coupled with additional increases in audit and legal fees.
Marketing department expenses increased $4.0 million, or 11.4%, primarily due to acceleration of certain tax season advertisements during the current period, which in the prior fiscal year occurred in the fourth quarter.
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Finance department expenses increased $2.6 million, or 53.4%,benefits decreased primarily as a result of increased insurance costs and consulting fees over$2.1 million of additional expenses related to deferred compensation plans in the prior year period.
The pretax loss was $14.0 million, compared with last year’s third quarter loss of $17.9 million.
year. The decrease in interest expense on acquisition debt is attributable to lower financing costs and a $39.8$45.1 million payment on acquisition debt in August 2002.
Corporate Operations &Interest Expense on Acquisition Debt — Nine-Month Results
| Nine months ended | |||||||||
| January 31, | January 31, | ||||||||
| 2003 | 2002 | ||||||||
| Operating revenues | $ | 4,137 | $ | 11,430 | |||||
| Eliminations | (4,185 | ) | (3,986 | ) | |||||
| Total revenues | (48 | ) | 7,444 | ||||||
| Corporate expenses: | |||||||||
| Compensation and benefits | 11,269 | 10,147 | |||||||
| Interest expense (1) | 2,728 | 7,951 | |||||||
| Marketing and advertising | 2,095 | 12,330 | |||||||
| Other | 19,074 | 9,683 | |||||||
| 35,166 | 40,111 | ||||||||
| Support departments: | |||||||||
| Information technology | 66,266 | 58,393 | |||||||
| Marketing | 50,196 | 43,347 | |||||||
| Finance | 20,935 | 12,186 | |||||||
| Other | 49,054 | 39,660 | |||||||
| 186,451 | 153,586 | ||||||||
| Allocation of shared services | (186,312 | ) | (154,507 | ) | |||||
| Investment income, net | 1,426 | 2,678 | |||||||
| Pretax loss | $ | (33,927 | ) | $ | (29,068 | ) | |||
| Interest expense on acquisition debt | $ | 54,990 | $ | 60,001 | |||||
Nine months ended January 31, 2003 compared to January 31, 2002
Revenues of a negative $48 thousand were $7.5 million lower than last year due primarily to $3.0 million in reduced interest income on operating investments, $2.1 million in additional revenues from supply sales to franchises allocated to other segments and a $1.7 million write-down in investments at the Company’s captive insurance subsidiary.
Corporate2003. Other expenses declined $4.9 million, or 12.3%, over the prior year, primarily due to lower marketing expenses. Marketing expenses decreased as a result of lower allocations of support department costs which are now charged directly to other segments.
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Corporate Operations.
Information technology department expenses increased $7.9$4.4 million, or 13.5%19.6%, primarily due to an increase of 16.3% in the number of employees over the nine months ended January 31, 2002. Equipment expenses also increased 12.2% due to the lease of additional computer hardware during the year.
Marketingheadcount and related facilities. Stock-based compensation expenses increased $6.8 million, or 15.8%, primarily due to acceleration of certain tax season advertisements during the current period, which in the prior fiscal year occurred in the fourth quarter.
Finance department expenses increased $8.7 million, or 71.8%, primarily as a result of increased insurance costs. In addition, consulting fees also increased over the prior year period.expensing of all stock-based compensation, which began on May 1, 2003.
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The pretax loss was $33.9$18.4 million, compared with last year’s second quarter loss of $29.1$31.5 million.
Due to the nature of this segment, the three months ended October 31, 2003 are not comparable to the three months ended July 31, 2003 and are not indicative of the expected results for the entire fiscal year.
Corporate Operations — Six-Month Results
| (in 000s) | Six months ended | |||||||||
| October 31, 2003 | October 31, 2002 | |||||||||
| Operating revenues | $ | 4,981 | $ | 2,291 | ||||||
| Eliminations | (2,965 | ) | (2,634 | ) | ||||||
| Total revenues | 2,016 | (343 | ) | |||||||
| Corporate expenses: | ||||||||||
| Compensation and benefits | 3,999 | 8,638 | ||||||||
| Interest expense: | ||||||||||
| Interest on acquisition debt | 34,746 | 36,976 | ||||||||
| Other interest | 264 | (1,555 | ) | |||||||
| Marketing and advertising | (78 | ) | 230 | |||||||
| Other | 9,714 | 12,364 | ||||||||
| 48,645 | 56,653 | |||||||||
| Support departments: | ||||||||||
| Information technology | 49,951 | 41,279 | ||||||||
| Marketing | 8,094 | 10,708 | ||||||||
| Finance | 15,734 | 13,405 | ||||||||
| Stock-based compensation | 4,124 | — | ||||||||
| Other | 23,891 | 24,313 | ||||||||
| 101,794 | 89,705 | |||||||||
| Allocation of corporate and shared costs | (101,798 | ) | (88,149 | ) | ||||||
| Investment income, net | 3,200 | 1,617 | ||||||||
| Pretax loss | $ | (43,425 | ) | $ | (56,935 | ) | ||||
Six months ended October 31, 2003 compared to October 31, 2002
Operating revenues increased $2.7 million as a result of a write-down of investments in the prior year.
Compensation and benefits decreased as a result of $5.5 million of additional expenses related to deferred compensation plans in the prior year. The decrease in interest expense on acquisition debt is attributable to lower financing costs and a $39.8$45.1 million payment on acquisition debt in August 2002.2003. Other expenses decreased as a result of lower allocations to Corporate Operations.
-49--56-
Information technology department expenses increased $8.7 million, or 21.0%, primarily due to an increase in headcount and related facilities. Stock-based compensation expenses increased as a result of the expensing of all stock-based compensation, which began on May 1, 2003.
The pretax loss was $43.4 million, compared with last year’s first quarter loss of $56.9 million.
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These comments should be read in conjunction with the Consolidated Balance Sheetscondensed consolidated balance sheets and Consolidated Statementscondensed consolidated statements of Cash Flowscash flows found on pages 1 and 3, respectively.
The Company’s liquidity needs are met primarily through a combination of operating cash flows, commercial paper (CP) issuance HRBFA client account assets and stock loans and whole loan sales.off-balance sheet financing arrangements.
OPERATING CASH FLOWS & LIQUIDITY BY SEGMENT
Operating cash flowsrequirements totaled negative $366.7$463.4 million and negative $920.8$349.8 million for the ninesix months ended JanuaryOctober 31, 2003 and 2002, respectively. WhileA condensed consolidating statement of cash flows by segment for the six months ended October 31, 2003 follows. Generally, interest is not charged on intercompany activities between segments.
| (in 000s) | U.S. Tax | Mortgage | Business | Investment | International | Corporate | Consolidated | ||||||||||||||||||||||
| Operations | Operations | Services | Services | Tax Operations | Operations | H&R Block | |||||||||||||||||||||||
| Cash provided by (used in): | |||||||||||||||||||||||||||||
| Operations | $ | (268,343 | ) | $ | 28,035 | $ | 13,285 | $ | (56,206 | ) | $ | 16,341 | $ | (196,462 | ) | $ | (463,350 | ) | |||||||||||
| Investing | (120,939 | ) | 61,237 | (4,785 | ) | 351 | (2,214 | ) | (25,037 | ) | (91,387 | ) | |||||||||||||||||
| Financing | — | 50,100 | (45,425 | ) | — | (107 | ) | (63,854 | ) | (59,286 | ) | ||||||||||||||||||
| Net intercompany | 397,255 | (144,844 | ) | 44,575 | 40,453 | (10,352 | ) | (327,087 | ) | — | |||||||||||||||||||
Net intercompany activities are excluded from the investing and financing activities within the segment cash flows. The Company believes that by excluding the intercompany activities, the cash flows by segment more clearly depict the cash generated and used by each segment. Had the intercompany activities been included, those segments in a net lending situation would have been included in investing activities, and those in a net borrowing situation would have been included in financing activities.
U.S. Tax Operations:U.S. Tax Operations has historically been the largest provider of annual operating cash flows are positive,to the seasonal nature of the U.S. Tax OperationsCompany. This segment typically results in negative operating cash flow throughgenerally operates at a loss during the first threetwo quarters of the fiscal year followed bydue to off-season costs and preparation activities for the upcoming tax season. The seasonal nature of U.S. Tax Operations generally results in a large positive operating cash flow in the fourth quarter. U.S. Tax Operations had total cash requirements of $389.3 million for the six months ended October 31, 2003.
FreeMortgage Operations:This segment generates cash flow isas a non-GAAP liquidity measure, which is definedresult of loan sales and securitizations, NIM transactions, sales of NIM residual interests and as its residual interests mature. Mortgage Operations generated $28.0 million in cash generated from operating activities reduced by capital expenditures, contingent paymentsprimarily from the sale and securitization of mortgage loans. This segment also generated $61.2 million in cash from investing activities primarily from cash received on prior acquisitions, debt payments, tax benefitsresidual interests, and $50.1 million in cash from financing activities as a result of the on-balance sheet securitization completed during the quarter.
Gains on stock option exercisessales of mortgage loans and other investingrelated assets totaled $412.9 million, of which 77% was received as cash. The cash was recorded as operating activities. Free cash flow, as defined, was negative $314.8 million
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Gains on sales of mortgage assets consist of the following:
| (in 000s) | Six months ended | |||||||
| October 31, 2003 | October 31, 2002 | |||||||
| Gains on whole loans sold by the Trusts | $ | 298,460 | $ | 216,908 | ||||
| Gains on loans securitized | 129,617 | 119,515 | ||||||
| Net change in receivable from the Trusts | 54,483 | 19,828 | ||||||
| Gains on retained mortgage servicing rights | 48,002 | 32,699 | ||||||
| Net change in fair value of rate-lock commitments | 613 | 4,615 | ||||||
| Additions to residual interests | 1,814 | 753 | ||||||
| Impairments to fair value of residual interests | (11,106 | ) | (24,132 | ) | ||||
| Origination expenses, net | (108,955 | ) | (73,801 | ) | ||||
| $ | 412,928 | $ | 296,385 | |||||
| Percent of gains received as cash | 77 | % | 89 | % | ||||
Cash received on residual interests in securitizations totaled $68.9 and negative $1.1 billion$103.9 for the ninesix months ended JanuaryOctober 31, 2003 and 2002, respectively,respectively.
The mortgage segment regularly sells loans as a source of liquidity for its prime and $604.1non-prime mortgages. Whole loan sales to the Trusts through October 31, 2003 were $11.6 billion compared with $7.8 billion for the same period in fiscal year 2003. Additionally, Block Financial Corporation (BFC) provides the mortgage segment a $150 million line of credit for working capital needs.
In order to finance its prime originations, the Company utilizes a warehouse facility with capacity up to $50 million, which expires in June 2004. The facility bears interest at one-month LIBOR plus 64 to 175 basis points. As of October 31, 2003, the balance outstanding under this facility was $1.6 million and is included in accounts payable, accrued expenses and other on the condensed consolidated balance sheets.
Management believes the sources of liquidity available to the Mortgage Operations segment are predictable and sufficient for its needs. Risks to the stability of these sources include external events impacting the asset-backed securities market. The liquidity available from the NIM transactions is also subject to external events impacting this market. These external events include, but are not limited to, adverse changes in the perception of the non-prime industry or in the regulation of non-prime lending and, to a lesser degree, reduction in the availability of third parties that provide credit enhancement. Performance of the securitizations will also impact the segment’s future participation in these markets. The four warehouse facilities used by the Trusts are subject to annual renewal, each at a different time during the year, in April, August, December and February and any of the above events could lead to difficulty in renewing the lines. These risks are mitigated by the availability of whole loan sales and financing provided by the Company, and to a lesser extent, by staggered renewal dates related to these lines.
Business Services:Business Services funding requirements are largely related to working capital needs. Funding is available from the Company sufficient to cover these needs. This
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segment generated $13.3 million in cash from operating activities primarily related to the collections of receivables in the first half of fiscal year 2004. Business Services used $45.4 million in financing activities, primarily as a result of payments on acquisition debt.
Investment Services:Investment Services used $56.2 million in cash from operating activities during the quarter, primarily due to the timing of cash deposits that are restricted for the benefit of customers.
Investment Services, through HRBFA, is subject to regulatory requirements intended to ensure the general financial soundness and liquidity of broker-dealers. HRBFA is required to maintain minimum net capital as defined under Rule 15c3-1 of the Securities Exchange Act of 1934 and complies with the alternative capital requirement, which requires a broker-dealer to maintain net capital equal to the greater of $250 thousand or 2% of the combined aggregate debit balances arising from customer transactions. The net capital rule also provides that equity capital may not be withdrawn or cash dividends paid if resulting net capital would be less than the greater of 5% of combined aggregate debit items or 120% of the minimum required net capital. As of October 31, 2003, HRBFA’s net capital of $120.3 million, which was 18.9% of aggregate debit items, exceeded its minimum required net capital of $12.7 million by $107.6 million. Although HRBFA has always exceeded its minimum net capital requirements, during the six months ended October 31, 2003 the Company contributed $32.0 million of additional capital to HRBFA.
To manage short-term liquidity, HRBFA maintains a $300 million unsecured credit facility with BFC, its indirect corporate parent. As of October 31, 2003 there were no outstanding balances on this facility.
Liquidity needs relating to client trading and margin-borrowing activities are met primarily through cash balances in client brokerage accounts and working capital. Management believes these sources of funds will continue to be the primary sources of liquidity for Investment Services. Stock loans have historically been used as a secondary source of funding and could be used in the future, if warranted.
Securities borrowed and securities loaned transactions are generally reported as collateralized financings. These transactions require the Company to deposit cash and/or collateral with the lender. Securities loaned consist of securities owned by customers, which were purchased on margin. When loaning securities, the Company receives cash collateral approximately equal to the value of the securities loaned. The amount of cash collateral is adjusted, as required, for market fluctuations in the value of the securities loaned. Interest rates paid on the cash collateral fluctuate as short-term interest rates change.
To satisfy the margin deposit requirement of client option transactions with the Options Clearing Corporation (OCC), Investment Services pledges customers’ margined securities. Pledged securities as of October 31, 2003 totaled $73.8 million, an excess of $18.6 million over the margin requirement.
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Management believes the funding sources for Investment Services are stable. Liquidity risk within this segment is primarily limited to maintaining sufficient capital levels to obtain securities lending liquidity to support margin borrowing by customers.
International Tax Operations:International Tax Operations provided $16.3 million in cash from operating activities during the quarter primarily due to higher earnings during the Australian tax season and collections of receivables from Revenue Canada related to its discounted return program.
International Tax Operations are generally self-funded. Cash balances are held in Canada, Australia and the United Kingdom independently in local currencies. H&R Block Canada has a commercial paper program up to $125 million (Canadian). At October 31, 2003, there was no commercial paper outstanding.
CAPITAL RESOURCES
Cash used in operating activities totaled $463.4 million for the six months ended October 31, 2003, compared with $349.8 million for the six months ended October 31, 2002.
Cash expenditures during the six months ended October 31, 2003 relating to investing and financing activities include the purchase of property and equipment ($43.6 million), payments on acquisition debt ($45.1 million), payment of dividends ($68.1 million), payments related to business acquisitions ($123.3 million) and the acquisition of treasury shares ($178.8 million).
Cash and cash equivalents — restricted totaled $571.2 million at October 31, 2003. HRBFA held $527.1 million of this total segregated in a special reserve account for the exclusive benefit of customers pursuant to Rule 15c3-3 of the Securities Exchange Act of 1934. Restricted cash held by Mortgage Operations totaled $32.6 million at October 31, 2003 as a result of cash held for outstanding commitments to fund mortgage loans. Restricted cash of $11.5 million at October 31, 2003 held by Business Services is related to funds held to pay payroll taxes on behalf of its clients.
On September 12, 2001, the Company’s Board of Directors authorized the repurchase of 15 million shares of common stock. On June 11, 2003 the Company’s Board of Directors approved an authorization to repurchase up to 20 million additional shares of its common stock. During the first half of fiscal year 2004, the Company purchased 4.1 million shares pursuant to these authorizations at an aggregate price of $177.6 million, or an average price of $42.99 per share. There are approximately 17.8 million shares remaining under the June 2003 authorization at October 31, 2003. The Company plans to continue to purchase its shares on the open market in accordance with this authorization, subject to various factors including the price of the stock, the ability to maintain progress toward a capital structure that will support a single A rating, the availability of excess cash, the ability to maintain liquidity and financial flexibility, compliance with securities laws and other investment opportunities available.
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OFF-BALANCE SHEET FINANCING ARRANGEMENTS
The Company has commitments to fund mortgage loans in its pipeline of $3.2 billion at October 31, 2003, subject to contract verification. External market forces impact the probability of loan commitments being closed, and therefore, total commitments outstanding do not necessarily represent future cash requirements. If the loan commitments are exercised, they will be funded through the Company’s off-balance sheet arrangements.
For the six months ended October 31, 2003, the final disposition of loans was 33% securitizations and 67% third-party whole loan sales. For the six months ended October 31, 2002, the final disposition of loans was 43% securitizations and 57% third-party whole loan sales.
In the second quarter of fiscal year 2004, the warehouse facilities utilized by the Trusts were increased to $5.0 billion. An additional $1.0 billion facility was added that expires in August 2004 and bears interest at one-month LIBOR plus 50 to 60 basis points. This facility is subject to similar performance triggers, limits and financial covenants as the other facilities. In November 2003, two of the existing $1.5 billion facilities were increased to $2.0 billion each, which increased the total warehouse facilities to $6.0 billion.
The Financial Accounting Standards Board (FASB) has decided to reissue its exposure draft, “Qualifying Special Purpose Entities and Isolation of Transferred Assets, an Amendment of FASB Statement No. 140,” during the first quarter of calendar year 2004. The purpose of the proposal is to provide more specific guidance on the accounting for transfers of financial assets to a QSPE.
Provisions in the first exposure draft, if adopted, may have required the Company to consolidate its current QSPEs (the Trusts) established in its Mortgage Operations segment. As of October 31, 2003, the Trusts had assets and liabilities of $3.8 billion. The provisions of the exposure draft are subject to FASB due process and are subject to change. The Company will continue to monitor the status of the exposure draft, and consider changes to current structures to comply with the proposed rules.
There have been no other material changes in the Company’s off-balance sheet financing arrangements from those reported at April 30, 2002. This calculation of free cash flow may not be comparable to that of other companies.2003 in the Company’s Annual Report on Form 10-K.
COMMERCIAL PAPER ISSUANCE
The Company participates in the United States and Canadian commercial paper markets to meet daily cash needs. Commercial paper is issued through Block Financial Corporation (BFC)by BFC and H&R Block Canada, Inc., wholly-ownedwholly owned subsidiaries of the Company. The following chart provides the debt ratings for BFC as of January 31, 2003:
The following chart provides the debt ratings for H&R Block Canada, Inc. as of January 31, 2003:
The Company incurredincurs short-term borrowings throughout the third quarteryear primarily to fund receivables associated with its Business Services segment, mortgage loans held for sale, seasonal working capital needs, dividend payments and purchases of treasury stock. Short-termBecause of the seasonality of its businesses, the Company has historically had short-term borrowings throughout
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the year. Borrowings of $124.6 million were $586.8 millionoutstanding at JanuaryOctober 31, 2003, compared with $1.6 billion$481.6 million at JanuaryOctober 31, 2002. The reduction was primarily a result of the RAL waiver agreement, whereby the Company waived its right to purchase participation interests in RALs during the 2003 tax season.
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The Company’sU.S. commercial paper issuances are supported by an unsecured committed linesline of credit (CLOCs). The United States issuances are supported by a $2.0 billion CLOC(CLOC) from a consortium of twenty-twotwenty-four banks. The $2.0 billion CLOC is subject to annual renewal in October of 2003,August 2004 and has a one-year term-out provision with a maturity date of October 22, 2004.in August 2005. This line is subject to various affirmative and negative covenants, including a minimum net worth covenant,covenants. This CLOC includes $1.5 billion for CP back-up and has not been drawn against. general corporate purposes and $500 million for working capital use, general corporate purposes and CP back-up. The CLOC was undrawn at October 31, 2003.
The Canadian issuances are supported by a credit facility provided by one bank in an amount not to exceed $125 million (Canadian), which also serves as. This line is subject to a working capital line for Canadian operations.minimum net worth covenant. The Canadian CLOC is subject to annual renewal in December of2003. The CLOC was undrawn at October 31, 2003.
Management believes the commercial paper market is stable. Risks to the stability of the Company’s commercial paper market participation would be a short-term rating downgrade, adverse changes in the Company’s financial performance, non-renewal or termination of the CLOCs, adverse publicity and operational risk within the commercial paper market such as the events on September 11, 2001.market. Management believes if any of these events were to occur, the CLOCs, to the extent available, could be used for an orderly exit from the commercial paper market, though at a higher cost to the Company. Additionally, the Company could turn to other sources of liquidity, including cash, other borrowings, debt issuance under the existing shelf registration and asset sales or securitizations.
OTHERCONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS
In April 2000, the Company issued $500 million of 81/2% Senior Notes, due 2007. The Senior Notes are not redeemable prior to maturity. The net proceeds of this transaction were used to repay a portion of the initial short-term borrowings for the OLDE Financial Corporation acquisition.
In October 1997, the Company issued $250 million of 63/4% Senior Notes, due 2004. The Senior Notes are not redeemable prior to maturity. The net proceeds of this transaction were used to repay short-term borrowings that initially funded the acquisition of Option One Mortgage Corporation (Option One).
Long-term debt at January 31, 2003 was comprised of the $750 million of Senior Notes described above, future payments related to the acquisitions of RSM McGladrey and other accounting firms of $120.0 million, and capital lease obligations and mortgage notes of $14.7 million.
As of January 31, 2003, the Company had $250 million remaining under its shelf registration of debt securities for additional debt issuance.
In connection with the Company’s acquisition of the non-attest assets of McGladrey & Pullen, LLP (McGladrey) in August 1999, the Company assumed certain pension liabilities related to McGladrey’s retired partners. The Company makes payments in varying amounts on a monthly basis. Included in other noncurrent liabilities at January 31, 2003 and April 30, 2002 is $25.3 million and $25.7 million, respectively, related to this liability.
In connection with the Company’s Business Services acquisitions, the purchase agreements provide for possible future contingent consideration, which is based on achieving certain revenue, profitability and working capital requirements over the next six years. Contingent
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payments of $20.3 million and $15.4 million were made during the nine months ended January 31, 2003 and 2002, respectively.
Business Services has commitments to fund certain attest entities, which are not consolidated, related to accounting firms it has acquired. Commitments also exist to loan up to $40 million to McGladrey & Pullen, LLP on a revolving basis through July 31, 2004, subject to certain termination clauses. This revolving facility bears interest at the prime rate plus four and one-half percent on the outstanding amount and a commitment fee of one-half percent per annum on the unused portion of the commitment.
Infiscal year 2000, HRB Royalty, Inc. (HRB Royalty), a wholly owned subsidiary of the Company, placed most of its major franchiseesfranchises on notice that it would not be renewing their respective franchise agreements as of the next renewal date. The renewalagreements have expired or will expire on varying dates vary among the major franchisees.in fiscal years 2004 and 2005. Pursuant to the terms of the applicable franchise agreements, HRB Royalty must pay the major franchisee a “fair and equitable price” for the franchise business and such price shall not be no less than eighty percent of the franchisee’s revenues for the most recent 12twelve months ended April 30, plus the value of equipment and supplies, and certain off-season expenses. The
During the six months ended October 31, 2003, franchise agreements of twelve major franchisees expired and subsidiaries of the Company expects to acquirebegan operating tax preparation businesses as company-owned operations in the franchise businesses overterritories of ten former major franchisees. With respect to the next severaltwo other franchisees with expired franchise agreements, one franchisee entered into a new franchise agreement with a limited term and one franchisee continued litigation challenging the expiration of the franchise agreement. Cash payments of $118.8 million were made or accrued related to these former major franchises during the six months ended October 31, 2003.
In August 2003, a subsidiary of the Company entered into a transaction with one of the former major franchisees whose franchise agreements expired in the first quarter, pursuant to which such subsidiary acquired the stock of the franchisee and the franchisee released the Company and its
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affiliates from any further liability regarding additional payments under the major franchise agreements. With the exceptions of the former franchisee that executed a release and the franchisee that entered into a new franchise agreement, the court will determine if any additional payments are required for these franchise businesses. The first trial relating to one major franchisee was held in October 2003. At the conclusion of this trial, the jury rendered a verdict and the court entered a judgment requiring the Company to make an additional payment of $3.2 million for the franchise business. As of October 31, 2003, the Company recorded this liability in accounts payable, accrued expenses and other on the condensed consolidated balance sheet. The original payment for the franchise business made in the first quarter of fiscal years, howeveryear 2004 was $5.0 million. The outcome of the trial is subject to post-trial motions and possible appeals.
In light of the continuing litigation and possible negotiation with the former major franchisees, there is no certainty regarding the ultimate amount of payments or that subsidiaries of the timingCompany will commence operations in all of the remaining former major franchise territories. Moreover, it is possible that HRB Royalty and certain former franchisees could agree to other arrangements, some of which may not require payments for the franchise businesses or cost of acquisition as to any franchise business due,related assets.
There have been no other material changes in part, tothe Company’s contractual obligations and commercial commitments from those reported at April 30, 2003 in the Company’s Annual Report on Form 10-K.
REGULATORY ENVIRONMENT
Certain state laws restrict or prohibit prepayment penalties on mortgage loans, and the Company relied on the federal Alternative Mortgage Transactions Parity Act (Parity Act) and related litigation.
Duringrules issued in the third quarter,past by the Office of Thrift Supervision (OTS), an office to preempt state limitations on prepayment penalties. The Parity Act was enacted to extend to financial institutions, other than federally chartered depository institutions, the federal preemption that federally chartered depository institutions enjoy. However, in September 2002, the OTS released a new rule that reduced the scope of the Department of Treasury, announced aParity Act preemption effective July 1, 2003 effective date forand, as a final ruleresult, the Company can no longer rely on the Parity Act to preempt state restrictions on prepayment penalties. The elimination of this federal preemption requires compliance with state restrictions on prepayment penalties. These restrictions prohibit the Company from charging any prepayment penalty in six states and restrict the amount or duration of prepayment penalties that will removethe Company may impose in an additional eleven states. This places the Company at a competitive disadvantage relative to financial institutions that continue to enjoy federal preemption of such state restrictions. Such institutions can charge prepayment and late fee rules from the list of OTS regulations applicablepenalties without regard to state housing creditors under the Alternative Mortgage Transaction Parity Act (Parity Act). The Parity Act, adopted in 1982, grants certain state-chartered housing creditors suchrestrictions and, as Option One and H&R Block Mortgage, parity with federally chartered lenders when makinga result, may be able to offer loans with payment featuresinterest rate and loan fee structures that vary from conventional fixed-rate, fixed-term mortgage loans. Once effective, Option Oneare more attractive than the interest rate and H&R Block Mortgage must comply with applicable state and local laws covering prepayment fees. The rule change regarding late fees will not affect Option One or H&R Block Mortgage as they already comply with state and local laws covering such fees. Theloan fee structures that the Company is evaluatingable to offer. It is estimated that the potentialnet impact to Mortgage Operations will be a reduction in revenues of approximately $35.0 million in fiscal year 2004 as a result of the rule change on its operations and financial results and developing strategies to mitigate any adverse effect. The rule change is not expected to have a material adverse effect on the Company's consolidated resultselimination of operations or financial position.prepayment penalties.
The United States, various state, local, provincial and foreign governments and some self-regulatory organizations have enacted statutes and ordinances, and/or adopted rules and
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regulations, regulating aspects of the businesses in which the Company’s subsidiaries are involved, including, but not limited to, commercial income tax return preparers, income tax courses, the electronic filing of income tax returns, the facilitation of refund anticipation loans, loan originations and assistance in loan originations, mortgage lending, privacy, consumer protection, franchising, sales methods, brokers, broker-dealers and various aspects of securities transactions, financial planners, investment advisors, accountants and the accounting practice. The Company’s subsidiaries seek to determine the applicability of such statutes, ordinances, rules and regulations (collectively, “Laws”)Laws) and comply with those Laws that apply to their activities. From time to time in the ordinary course of business, the Company and its subsidiaries receive inquiries from governmental and self-regulatory agencies regarding the applicability of Laws to the products and services offered by the Company’s subsidiaries. In response to past inquiries, the Company’s subsidiaries have agreed to comply with such Laws, convinced the authorities that such Laws were not applicable or that compliance already exists, and/or modified such subsidiaries’ activities in the applicable jurisdiction to avoid the application of all or certain parts of such Laws. The Company’s management believes that the past resolution of such inquiries and its ongoing compliance with Laws have not had a material adverse effect on the consolidated results of operations or financial conditionstatements of the Company and its subsidiaries. The Company cannot predict what effect future Laws, changes in interpretations of existing Laws, or the results of future regulator inquiries with respect to the applicability of Laws may have on the Company’s subsidiaries, the consolidated results of operations or the financial conditionstatements of the Company and its subsidiaries.
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LIQUIDITY BY STRATEGIC BUSINESS UNIT
U.S. Tax Operations:
U.S. Tax Operations has historically been the largest provider of annual operating cash flows to the Company.
International Tax Operations:
International Tax Operations are generally self-funded, with the exception of the United Kingdom. Cash balances are held in Canada and Australia in local currencies. At January 31, 2003, there was no Canadian commercial paper outstanding.
Mortgage Operations:
Through Option One Mortgage Corporation (OOMC) and H&R Block Mortgage Corporation (HRBMC), this segment is primarily engaged in the origination and sale of mortgage loans and related assets and provides servicing for non-prime loans. In order to reduce the Company’s capital investment in its non-prime mortgage operations, the Company entered into third-party off-balance sheet arrangements beginning in April 2000, renewable annually. These arrangements are primarily used to purchase mortgage loans, but a portion may also be used to finance servicing advances and residual interests. The arrangements have freed up cash and short-term borrowing capacity, improved liquidity and flexibility, and reduced balance sheet risk, while providing stability and access to liquidity in the secondary market. The prime loans originated through HRBMC are sold through whole loan sales.
The Company originates mortgage loans and sells most loans the same day in a whole loan sale to the Trusts. The sale is recorded in accordance with Statement of Accounting Standards No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” The Trusts purchase the loans from the Company utilizing three warehouse facilities totaling $4.0 billion. These facilities are subject to various OOMC performance triggers, limits and financial covenants, including tangible net worth and leverage ratios. As a result of the whole loan sale to the Trusts, the Company records a receivable from the Trusts for the present value of the portion of the net spread (the difference between the rate on the loans and the financing cost of the Trusts) plus prepayment penalty income. This receivable is included in prepaid and other current assets on the consolidated balance sheets.
The Trusts then have two options to ultimately dispose of the mortgage loans, either through a securitization or a whole loan sale. The ultimate disposition of the loans by the Trusts determines the treatment of the receivable from the Trusts and the timing of the receipt of cash related to this receivable.
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If the Trusts choose to sell the mortgage loans in a whole loan sale, cash received by the Company for its receivable is subject to the net execution price obtained in the sale of the mortgage loans.
If the Trusts choose to securitize the mortgage loans, the Company then pledges its receivable and the Trusts pledge the related mortgage loans to a securitization trust to reconstitute the loans. The securitization trust then securitizes the reconstituted mortgage loans. At this point, the Company’s receivable is restructured and recharacterized as a residual interest from the securitized mortgage loans. These residual interests are classified as trading and are included in marketable securities-trading on the Consolidated Balance Sheets.
To enable the Company to accelerate a significant portion of the cash flow from residual interests rather than receiving those cash flows over the life of the securitization, the Company securitizes its residual interests in a NIM transaction. From the NIM transaction, the Company receives cash and retains a much smaller residual interest. Generally, these residuals do not begin to receive cash collections for two to three years. These residual interests are classified as available-for-sale.
The Company began receiving cash collections from its residual interests in fiscal year 2002, which reduced the outstanding balance of the residuals. Cash received on these residual interests was $117.5 million for the nine months ended January 31, 2003, compared with $33.0 million for the comparable period in fiscal year 2002.
During the third quarter, the Company completed the sale of $206.6 million of residual interests from prior securitizations. The transaction, which closed on November 15, 2002, netted the Company $142.5 million in cash. The gain on this transaction is reflected as a separate line item in the Consolidated Statements of Operations, and in the Mortgage Operations segment, where applicable.
For the nine months ended January 31, 2003, the final disposition of loans by the Trusts was 65.2% securitizations and 34.8% whole loan sales. For the nine months ended January 31, 2002, the final disposition of loans by the Trusts was 84.4% securitizations and 15.6% whole loan sales.
The majority of revenues from Mortgage Operations are generated by sales of mortgage assets. Gains on sales of mortgage assets consist of the following:
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| Nine months ended | ||||||||
| January 31, | January 31, | |||||||
| 2003 | 2002 | |||||||
| Gain on whole loans sold by the Trusts | $ | 267,499 | $ | 38,868 | ||||
| Gain on loans securitized by the Trusts | 224,085 | 288,148 | ||||||
| Gain on sale of residual interests previously securitized | 130,881 | — | ||||||
| Gain on loans still held by the Trusts | 73,494 | 57,385 | ||||||
| Gain on mortgage servicing rights | 50,691 | 37,564 | ||||||
| Net change in mark-to-market on pipeline loans | 1,906 | 542 | ||||||
| Adjustments to fair value of residual interests | (25,589 | ) | (29,642 | ) | ||||
| Origination expenses | (120,218 | ) | (70,563 | ) | ||||
| 602,749 | 322,302 | |||||||
| Percent of gain received as cash | 83 | % | 80 | % | ||||
The Company has commitments to fund mortgage loans in its pipeline of $2.3 billion at January 31, 2003, subject to contract verification. External market forces impact the probability of loan commitments being closed, and therefore, total commitments outstanding do not necessarily represent future cash requirements. If the loan commitments are exercised, they will be funded in the manner described above.
The mortgage segment regularly sells loans as a source of liquidity for its prime and non-prime mortgages. Whole loan sales through January 31, 2003 were $12.4 billion compared with $8.2 billion for the same period in fiscal year 2002. Additionally, BFC provides the mortgage segment a $150 million line of credit for working capital needs.
Management believes the sources of liquidity available to the Mortgage Operations segment are predictable and sufficient for its needs. Risks to the stability of these sources include external events impacting the asset-backed securities market. The liquidity available from the NIM transactions is also subject to external events impacting this market. These external events include, but are not limited to, adverse changes in the perception of the non-prime industry or in the regulation of non-prime lending and, to a lesser degree, reduction in the availability of third parties that provide credit enhancement. Performance of the securitizations will also impact the segment’s future participation in these markets. The three warehouse facilities used by the Trusts are subject to annual renewal, each at a different time during the year, in January, April and July and any of the above events could lead to difficulty in renewing the lines. These risks are mitigated by the availability of whole loan sales and financing provided by the Company.
The Financial Accounting Standards Board (FASB) has proposed changes to the accounting for residual interests in securitizations in an interpretation of Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (SFAS 133). The interpretation, if finalized with the proposed provisions, may impact the Company’s ability to record NIM transactions utilizing its current structure and maintain its current accounting treatment. The Company has not yet determined the impact, if any, of the proposed interpretation on its financial statements.
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Investment Services:
Liquidity needs relating to client trading and margin-lending activities are met primarily through cash balances in client brokerage accounts and working capital. Management believes these sources of funds will continue to be the primary sources of liquidity for Investment Services. Stock loans have been used as a secondary source of funding in the past and could be in the future, if warranted.
Investment Services, through HRBFA, is subject to regulatory requirements that are intended to ensure the general financial soundness and liquidity of broker-dealers.
HRBFA is required to maintain minimum net capital as defined under Rule 15c3-1 of the Securities Exchange Act of 1934 and has elected to comply with the alternative capital requirement, which requires a broker-dealer to maintain net capital equal to the greater of $1 million or 2% of the combined aggregate debit balances arising from customer transactions. The net capital rule also provides that equity capital may not be withdrawn or cash dividends paid if resulting net capital would be less than the greater of 5% of combined aggregate debit items or $1 million. At January 31, 2003, HRBFA’s net capital of $106.1 million, which was 18.5% of aggregate debit items, exceeded its minimum required net capital of $11.5 million by $94.6 million.
To manage short-term liquidity, HRBFA maintains a $300 million unsecured credit facility with BFC, its indirect corporate parent. As of January 31, 2003, HRBFA had a $125 million letter of credit with a financial institution. As of January 31, 2003, no amounts were drawn on this letter of credit.
Securities borrowed and securities loaned transactions are generally reported as collateralized financings. These transactions require the Company to deposit cash and/or collateral with the lender. Securities loaned consist of securities owned by customers, which were purchased on margin. When loaning securities, the Company receives cash collateral approximately equal to the value of the securities loaned. The amount of cash collateral is adjusted, as required, for market fluctuations in the value of the securities loaned. Interest rates paid on the cash collateral fluctuate as short-term interest rates change.
To satisfy the margin deposit requirement of client option transactions with the Options Clearing Corporation (OCC), Investment Services pledges customers’ margined securities. Pledged securities at January 31, 2003 totaled $34.1 million, an excess of $3.1 million over the margin requirement. In January 2002, Investment Services provided the OCC with letters of credit of $45.0 million to satisfy the $40.0 million margin requirement. The letters of credit were collateralized by customers’ margined securities.
Management believes the funding sources for Investment Services are stable. Liquidity risk within this segment is primarily limited to maintaining sufficient capital levels to obtain securities lending liquidity to support margin borrowing by customers.
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Business Services:
Business Services’ funding requirements are largely related to “work in process” and accounts receivable. A line of credit is available from the Company sufficient to cover this segment’s working capital needs.
CAPITAL RESOURCES
Cash used in operating activities totaled $366.7 million for the nine months ended January 31, 2003, compared with $920.8 million for the nine months ended January 31, 2002. Cash used in operations was primarily impacted by the increase in receivables of $130.4 million for the nine months ended January 31, 2003 compared to $916.0 million for the nine months ended January 31, 2002. The decline in the receivable balance is primarily due to the waiver of the Company’s right to purchase participation rights in RALs, which reduced the receivable balance by $737.7 million compared to January 31, 2002.
Cash expenditures during the nine months ended January 31, 2003 relating to investing and financing activities include the purchase of property and equipment ($95.6 million), payment of dividends ($93.6 million) and the acquisition of treasury shares ($317.6 million).
Cash and cash equivalents, including restricted balances, totaled $855.6 million at January 31, 2003. Investment Services held $459.2 million of the $855.6 million, of which $392.9 million was segregated in a special reserve account for the exclusive benefit of customers pursuant to Rule 15c3-3 of the Securities Exchange Act of 1934 (restricted cash). Investment Services’ restricted cash balance has risen 53.0% from $256.8 million at April 30, 2002. Payables to customers have become larger than customer margin balances due to unstable equity markets. The remaining cash and cash equivalents held by Investment Services reflect excess cash remaining from the firm and clients after funding margin debits and security settlements. Restricted cash held by Mortgage Operations totaled $12.8 million at January 31, 2003 as a result of cash held for outstanding commitments to fund mortgage loans. Restricted cash of $13.0 million at January 31, 2003 held by Business Services is related to funds held to pay payroll taxes on behalf of its clients.
Working capital decreased to $209.5 million at January 31, 2003 from $365.4 million at April 30, 2002. The working capital ratio at January 31, 2003 is 1.10 to 1, compared to 1.19 to 1 at April 30, 2002. A large portion of tax return preparation occurs in the fourth quarter and has the effect of increasing certain assets and liabilities during the fourth quarter, including cash and cash equivalents, receivables, accrued salaries, wages and payroll taxes and accrued taxes on earnings.
In March 2000, the Company’s Board of Directors approved an authorization to repurchase up to 12 million shares of its common stock. Repurchases under the March 2000 authorization were completed in September 2001. On September 12, 2001, the Company’s Board of Directors authorized the repurchase of 15 million shares of common stock. During fiscal year 2002, the Company repurchased 12.2 million shares (split-adjusted) pursuant to these authorizations at an aggregate price of $462.5 million or an average price of $37.76 per share. In the nine months ended January 31, 2003, the Company purchased 6.6 million shares at an aggregate price of $316.6 million, or an average price of $47.94 per share. As of January 31, 2003, there were
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approximately 1.9 million shares remaining under the September 2001 authorization. The Company plans to continue to purchase its shares on the open market in accordance with this authorization, subject to various factors including the relative market price to an estimate of intrinsic value of the stock, the ability to maintain progress toward a financial and capital structure that will support a mid single A rating, the availability of excess cash, the ability to maintain liquidity and financial flexibility, securities laws restrictions and other investment opportunities available.
Definition of Non-GAAP Financial Measures
The Company provides readers financial measures generated using generally accepted accounting principles and will, from time to time, provide non-GAAP financial measures, as management believes such measures aid in the analysis and comparability of its financial results. A non-GAAP financial measure is a numerical measure of financial performance, financial position or cash flows that excludes or includes amounts included or excluded from the most directly comparable financial measures calculated and presented in accordance with generally accepted accounting principles.
Cash earnings are a non-GAAP financial measure, that the Company defines as net earnings excluding the after-tax effect of amortization expense of acquired intangible assets and, when applicable, goodwill impairment. The Company utilizes cash earnings to evaluate its resource generation capacity in order to make capital allocation and reinvestment decisions. Net earnings is the most comparable GAAP financial measure.
Free cash flow is a non-GAAP liquidity measure that the Company defines as operating cash flow reduced by capital expenditures, contingent payments on prior acquisitions, debt payments, tax benefits on stock option exercises and other investing activities. The Company utilizes free cash flow to evaluate its level of uncommitted cash flows generated from operations. Net cash flow from operating activities is the most comparable GAAP financial measure.
Management believes cash earnings and free cash flow are meaningful to investors as they provide analysis of operating results using the same measures used the by the Company's chief decision makers in the execution of the Company's business strategies.
Following are reconciliations of cash earnings to GAAP earnings and free cash flow to cash flows from operating activities:
Cash Earnings(in thousands, except per share data)
| Three Months Ended | Nine Months Ended | |||||||||||||||
| January 31, | January 31, | |||||||||||||||
| 2003 | 2002 | 2003 | 2002 | |||||||||||||
| Net earnings (loss) | $ | 132,313 | $ | 29,616 | $ | 85,422 | $ | (29,179 | ) | |||||||
| Amortization expense, net of taxes | 9,999 | 9,765 | 30,108 | 28,687 | ||||||||||||
| Goodwill impairment | — | — | 24,000 | — | ||||||||||||
| Cash earnings (loss) | $ | 142,312 | $ | 39,381 | $ | 139,530 | $ | (492 | ) | |||||||
| Earnings (loss) per diluted share | $ | .73 | $ | .16 | $ | .46 | $ | (.16 | ) | |||||||
| Cash earnings (loss) per diluted share | $ | .78 | $ | .21 | $ | .76 | $ | .00 | ||||||||
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Free Cash Flow(in thousands)
| Nine Months Ended | Year Ended | |||||||||||||||
| January 31, | April 30, | |||||||||||||||
| 2003 | 2002 | 2002 | 2001 | |||||||||||||
| Cash from operating activities | $ | (366,749 | ) | $ | (920,848 | ) | $ | 741,446 | $ | 248,351 | ||||||
| Capital expenditures | (95,629 | ) | (71,343 | ) | (111,775 | ) | (92,411 | ) | ||||||||
| Debt payments | (52,107 | ) | (49,479 | ) | (55,845 | ) | (72,579 | ) | ||||||||
| Contingent payments on acquisitions | (20,256 | ) | (15,386 | ) | (16,833 | ) | (5,145 | ) | ||||||||
| Tax benefit on stock option exercises | (31,168 | ) | (55,004 | ) | (57,809 | ) | (2,235 | ) | ||||||||
| Changes in available for sale securities | 259,161 | 57,514 | 91,252 | 367,080 | ||||||||||||
| Other changes, net | (8,027 | ) | (9,869 | ) | 13,619 | 7,116 | ||||||||||
| Free cash flow | $ | (314,775 | ) | $ | (1,064,415 | ) | $ | 604,055 | $ | 450,177 | ||||||
Forward-looking informationFORWARD-LOOKING INFORMATION
The information contained in this Form 10-Q and the exhibits hereto may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Such statements are based upon current information, expectations, estimates and projections regarding the Company, the industries and markets in which the Company operates, and management’s assumptions and beliefs relating thereto. Words such as “will,” “plan,” “expect,” “remain,” “intend,” “estimate,” “approximate,” and variations thereof and similar expressions are intended to identify such forward-looking statements. These statements speak only as of the date on which they are made, are not guarantees of future performance, and involve certain risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results could materially differ from what is expressed, implied or forecast in such forward-looking statements. Such differences could be caused by a number of factors including, but not limited to, the uncertainty of laws, legislation, regulations, supervision and licensing by Federal, state and local authorities and self-regulatory organizations and their impact on any lines of business in which the Company’s subsidiaries are involved; unforeseen compliance costs; the uncertainty that the Company will achieve or exceed its revenue, earningsincome and earnings per share growth goals and expectations for fiscal year 2003;2004; the uncertainty that actual fiscal year 20032004 financial results will fall within the guidance provided by the Company; the uncertainty that the growth rate for mortgage originations in the Mortgage Operations segment will equal or exceed the growth rate experienced in fiscal year 2003 or the first and second quarters of fiscal year 2004; the uncertainty as to the effect on the consolidated financial statements of the adoption of accounting pronouncements; risks associated with sources of liquidity for each of the lines of business of the Company; changes in interest rates; changes in economic, political or regulatory environments; changes in competition and the effects of such
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changes; the inability to implement the Company’s strategies; changes in management and management strategies; the Company’s inability to successfully design, create, modify and operate its computer systems and networks; the uncertainty of assumptions utilized to estimate cash flows from residual interests in securitizations and mortgage servicing rights; the uncertainty of assumptions and criteria used in the testing of goodwill and long-lived assets for impairment; litigation involving the Company and its subsidiaries; the uncertainty as to the outcome of any settlementslitigation; the uncertainty as to the timing or cost of commencement of operations in former major franchise territories or the RAL litigation will ultimatelyfair and equitable price to be approved by the courts;paid for any major franchise business; and risks described from time to time in reports and registration statements filed by the Company and its subsidiaries with the Securities and Exchange Commission. Readers should take these factors into account in evaluating any such forward-looking statements. The Company undertakes no obligation to update publicly or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
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There have been no material changes in market risk from those reported at April 30, 2002.2003 in the Company’s Annual Report on Form 10-K.
Disclosure controls and procedures are controls and other procedures that are designed to ensure information required to be disclosed in reports filed or submitted under the Securities Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure such information is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer or persons performing similar functions, as appropriate, to allow timely decisions regarding required disclosures.
In conjunction with management, including the Chief Executive Officer and Chief FinancialPrincipal Accounting Officer, the Company has evaluated the effectiveness of the design and operation of its disclosure controls and procedures within 90 days prior toas of the filing dateend of the period covered by this quarterly report. Based on this evaluation, the Chief Executive Officer and Chief FinancialPrincipal Accounting Officer have concluded these controls and procedures are effective. There have been no significant changes in internal controls, or in other factors, which would significantly affect these controls subsequent to the date of evaluation.
Disclosure controls and procedures are designed to ensure information is recorded, processed, summarized and reported within the time periods specified by the Securities and Exchange Commission. Disclosure controls and procedures include controls and procedures that ensure accumulation and communication of information to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.
PART II — OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
RAL Litigation
The Company reported in its current reports on Forms 8-K, dated November 1, 2002, November 6, 2002, November 14, 2002, November 15, 2002previous quarterly reports on Form 10-Q and November 18, 2002, andin its quarterlyannual report on Form 10-Q10-K for the quarteryear ended October 31, 2002,April 30, 2003, certain events and information relating to class action litigation and putative class action litigation involving its
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subsidiaries’ refund anticipation loan (RAL) program.programs (collectively, “RAL Cases”). The Company has defended numerous class action and putative class action lawsuits filed against it involving the RAL program and a variety of legal theories asserted by plaintiffs. The amounts claimed in these lawsuits have been substantial in some instances. Of the cases that are no longer pending, some were dismissed on the Company’s motions for dismissal or summary judgment, some were dismissed voluntarily by the plaintiffs after a denial of class certification, and some were settled. Two RAL Cases involving statewide classes (discussed below) had final trial court approvals of settlements during the first six months of fiscal year 2004 and two other RAL Cases were dismissed in August 2003 in connection with one of those settlements. One new putative class action RAL Case was filed in August 2003. The Company continues to believe it has meritorious defenses to the RAL Cases and intends to defend the remaining RAL Cases vigorously. However, there can be no assurances as to the outcome of the pending RAL Cases individually or in the aggregate, and there can be no assurances on and the impact of the RAL Cases on the Company’s financial position. The following is updated information regarding those cases identified in the Company’s current report on Form 8-K dated November 6, 2002,pending RAL Cases in which developments occurred during or after the third quarter or subsequent thereto, as well as information concerning a putative class action RAL case filed during the third quarter.three months ended October 31, 2003:
Ronnie and Nancy Haese, et al. v. H&R Block Inc., et al., Case No. CV96-4213, District Court of Kleberg County, Texas, (“Haese I”) and;andRonnie and Nancy Haese, et al. v. H&R Block Inc., et al., Case No. CV-99-314-D, District Court of Kleberg County, Texas (“Haese II”), filed originally as one action on July 30, 1996. The trial court judge inHaeseI issued a letter on November 6, 2002, indicating that he intended to grant plaintiffs’ motion for partial summary judgment and motion for forfeiture, thereby holding that a fiduciary relationship exists between a tax preparer and its customer and that the company and its franchisee must forfeit fees totaling $74.9 million. On November 19, 2002, the Company announced that a settlement had been reached pursuant to which if approved, the Company and its major franchisee wouldwill issue coupons to class members that may be redeemed over a five-consecutive-year period once there isfollowing final approval of the settlement and once all appeals have been exhausted. Each class member wouldwill receive a packet containing 15 coupons under the settlement (one mailing).settlement. Three coupons wouldwill be redeemable each year — one for a $20 rebate offon tax preparation or electronic filing services at Block offices, one that may be redeemed for TaxCut®TaxCut Platinum tax preparation software (or a product of equivalent value), and one that may be redeemed
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forTax Planning Advisor, a tax planning book.book (or a product of equivalent value). The settlement also provides that defendants would alsowill be responsible for the payment of court-approved legal fees up to $49 million and expenses of class counsel up to $900,000. Following the endAs a result of the thirdsettlement announcement, the Company recorded a liability and pretax expense of $41.7 million during the second quarter of fiscal year 2003, which represented, at that time, the Company’s best estimate of its share of the settlement cost for plaintiff class attorneys’ fees and expenses, tax products and associated mailing expenses. The Company paid the award of $49.9 million of attorneys’ fees and expenses to class counsel on August 22, 2003. During the fourth quarter of fiscal year 2003 and prior to the filing of the final settlement agreement with the court and any motions for preliminary approval of the settlement and legal fees and expenses of class counsel, the plaintiffs had filed a motion asking the Texas court to direct that $26 million of awarded class counsel fees be paid to the plaintiff class members. The defendants filed an objection toA hearing on the motion, statingfinal approval of the motionsettlement agreement was premature, defendants had not agreed to suchheld on June 24, 2003, and the judge entered a payment tofinal judgment on June 24, 2003 fully and finally approving the settlement agreement, finding it fair, adequate and reasonable and that it protects the rights of the class, asis in the best interests of the settlement class and meets all criteria required by Texas law. As a part of the settlement,final judgment, the court also (1) dismissed with prejudice the claims of class members who obtained RALs in Texas during the period from 1992 through 1996; (2) granted defendants’ Supplemental Motion for Summary Judgment as to class members who only
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obtained RALs from 1988 through 1991, and ordered that such defendants objecttake nothing on their claims against the defendants; (3) granted defendants’ Motion to making paymentsCompel Arbitration as to those members of the plaintiff class on behalfwho obtained a RAL for the first time from 1997 to 2002, and dismissed the claims of theirthose class members without prejudice as to those members’ rights to pursue those claims through binding arbitration; (4) vacated its January 30, 1998 Order pertaining to arbitration clauses and contacts with the class; and (5) withdrew its rulings as to fiduciary duty, breach or the nature of the breach thereof, and for forfeiture as reflected in the Court’s November 6, 2002 letter. In a separate Order dated June 24, 2003, the Court found that the awarding of attorneys’ and expenses was appropriate and ordered that class counsel and objectors’ class counsel be awarded attorneys’ fees in the defendants should notamount of $49.0 million on condition that, upon payment of the fees to class counsels’ trust account, class counsel shall pay $26.0 million of the attorneys’ fees to the class members pursuant to an approved distribution plan. The Order also provided that $100,000 from the award of attorneys’ fees be compelledused to incur any expense relatedcreate a cy pres fund pursuant to an approved cy pres plan and specified the manner in which the remaining award of attorneys’ fees was to be distributed among the class counsel and objectors’ class counsel. There were no appeals of such payments. That motion is pending. Thefinal judgment and Order relating to attorneys’ fees and expenses. In addition to the liability that has already been recorded and/or paid, the Company will reduce revenues associated with tax preparation services as the coupons are redeemed each year. Distribution of the settlement is subject to court approval and there are no assurances that such approval will be obtained.coupons was made following the end of the second quarter.
Haese IIarose from Plaintiffs’plaintiffs’ splitting off some claims fromHaese Iclaims based upon allegations of usury. Inand, in connection with the settlement inofHaese I, plaintiffs have agreed to take action to obtain the dismissal ofHaese II.case was dismissed on August 20, 2003.
Veronica I. Martinez, et al. v. H&R Block, Inc., et al., Case No. 02-3629-E in the District Court of Nueces County, Texas. In connectionTexas, was dismissed on August 20, 2003, in accordance with the settlement agreement involved in the settlement ofHaese I, plaintiffs’ counsel has agreed to take action to dismiss this putative class action..
Lynne A. Carnegie, et al. v. Household International, Inc., H&R Block, Inc., et al., (formerlyJoel E. Zawikowski, et al. v. Beneficial National Bank, H&R Block, Inc., Block Financial Corporation, et al.), Case No. 98 C 2178, United States District Court for the Northern District of Illinois, Eastern Division (referred to asCheryl Reynolds, et al. v. Beneficial National Bank, et al.in Seventh Circuit Court of Appeals decision issued inDivision. On April 2002). On remand from the Seventh Circuit Court of Appeals,15, 2003, the District Court held hearings in October and November 2002 with respectjudge declined to approve a $25 million settlement of this matter, finding that counsel for the fairness and adequacysettlement plaintiffs had been inadequate representatives of the proposed settlement. Atplaintiff class and failed to sustain their burden of showing that the conclusionsettlement was fair. The judge appointed new counsel for the plaintiffs in May 2003 and named their client, Lynne Carnegie, as lead plaintiff. The new counsel for the plaintiffs filed an amended complaint and a motion for partial summary judgment during the quarter ended July 31, 2003. The defendants filed a motion to dismiss, a brief in response to allegations in the plaintiffs’ amended complaint relating to class certification, and responses to plaintiffs’ motion for partial summary judgment. Extensive discovery is proceeding. In the fourth quarter of fiscal year 2003, the fairness hearing on November 15,Company recorded a receivable in the judge took the matter under advisement, permitting the objectors to the proposed settlement to file briefs as to the fairnessamount of its $12.5 million share of the settlement fund and permittingrecorded a reserve of $12.5 million consistent with the plaintiffs and defendants to file reply briefs in further supportexisting settlement authority of the settlement. Briefing concluded in December 2002Board of Directors. The defendants requested the release of the escrowed settlement fund and the judge has not yet ruled onCompany’s $12.5 million share of such fund was received during the fairnesssecond quarter of fiscal year 2004. The Company intends to defend the settlement. There can becase vigorously and there are no assurances that the District Courtmatter will approveresult in a settlement or as to the settlement as currently contemplated.amount of any settlement.
Joyce A. Green, et al. v. H&R Block, Inc., Block Financial Corporation, et al., Case No. 97195023, in the Circuit Court for Baltimore City, Maryland. A hearing on the Company’s motion for summary judgment on all counts was held on November 21, 2002, and the judge denied the motion on that day. The trial was scheduled for January 7, 2003. In response to defendants’ motion to stay the trial, at a hearing on January 7, the judge granted the motion to stay the trial until a ruling on the fairness of the settlement in theZawikowskicase is rendered and all appeals of the Chicago ruling are exhausted.
Sandra J. Basile, et al. v. H&R Block, Inc. et al., April Term 1993 Civil Action No. 3246, in the Court of Common Pleas, First Judicial District of Pennsylvania, Philadelphia County. The Company moved to decertify the class in this matter and oral argument on the motion was held
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on December 16, 2002. The judge took the matter under advisement and a ruling has not yet been made.
Belinda Peterson, et al. v. H&R Block Tax Services, Inc., Case No. 95CH2389, in the Circuit Court of Cook County, Illinois. Defendants’ motionA settlement was reached in April 2003 involving an estimated maximum total amount of $295,000. As a part of the settlement, class members who submit a claim will receive $25 in cash, with a guaranteed minimum total payout of $40,000 and a maximum total payout of $55,000. Class counsel will receive $220,000, the named class representative will receive $5,000, and it is expected that it will cost up to decertify$15,000 to administer the class is pending. This case is scheduled for trialsettlement. Preliminary approval of the settlement was granted on June 12, 2003 and notices of the settlement and claim forms have been sent to the class. The settlement was approved and a judgment entered after a final fairness hearing held in MayOctober 2003.
Levon and Geral Mitchell, et al. v. H&R Block and Ruth R. Wren, Case No. CV-95-2067, in the Circuit Court of Mobile County, Alabama. The remaining claimcourt granted plaintiffs’ motion for class certification during the quarter ended July 31, 2003, and the defendants filed their notice of appeal regarding such certification on August 14, 2003.
Roy Carbajal, et al. v. H&R Block Tax Services, Inc., et al., Case No. 00C-0626 in this matter is a breachthe United States District Court for the Northern District of fiduciary duty claim relating to the RAL program. Class certification was denied by the court. That denial was reversed by the Alabama Supreme Court and remanded for further consideration. A hearing on a newIllinois. The defendants’ motion to certify a classcompel arbitration was heldgranted on February 21, 2003. The judge tookSeptember 16, 2003, and the matter under advisement and has not yet ruled on it.case was dismissed. Plaintiffs have appealed.
Deadra D. Cummins,Abby Thomas, et al. v. Beneficial National Bank, H&R Block, Inc., et al.,Civil ActionCase No. 03-C-134,4:03-CV-00775 GTE in the United States District Court for the Eastern District of Arkansas, Western Division, was originally filed in the Circuit Court for Phillips County, Arkansas on August 12, 2003, and was subsequently removed to federal court. It is a putative class action filed on January 22, 2003, in state court in Kanawha County, West Virginia, in which plaintiffs allege three counts involvingalleging fraudulent misrepresentation, fraudulent concealment, dual agency, breach of fiduciary duty, breachviolation of West Virginia statute on credit service organizations,Arkansas Deceptive and Unconscionable Trade Practices Law, violation of Arkansas’ Secret Payments or Allowance of Rebates and Refunds Law, unjust enrichment, breach of contract unjust enrichment, and unfair or deceptive acts or practicesdeceit in connection with respect to the RAL program. The plaintiffs’ complaint statesrequests that the court certify a nationwide class soughtof all persons who obtained a RAL from September 1987 through December 1997, who do not have an arbitration provision in their contract. It also seeks a subclass of class members who are 60 years of age or older, or who are Disabled Persons under Arkansas Statutes section 4-88-201. Plaintiffs seek an unspecified amount of damages, restitution, equitable relief, attorneys’ fees, and costs of court. Defendants have moved to be certified encompassesdismiss and compel arbitration. Plaintiffs thereafter filed an amended complaint and a motion to remand the case to state court. On December 8, 2003, the federal court denied plaintiffs’ motion to remand.
Dennis J. Smith v. H&R Block, et al., Case No. 3:03CV7181 in the United States District Court for the Northern District of Ohio, Western Division. The Company was not served with the original complaint filed in the matter. The Company was served with an amended complaint in November 2003, alleging RICO violations, fraud, breach of fiduciary duties, negligence, conversion, and violation of Ohio consumer fraud statutes as a result of the wrongful deprivation of all West Virginia residents who participated inor part of plaintiff’s tax refunds under the “Rapid Refund” program. The complaint generally alleges violations of the Fair Debt Collection Practices Act and appears to relate to the
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cross-collection of prior RAL debt by banks involved in the RAL program foror the past 10 years.refund anticipation check program. The defendants have removed the case to federal court.amended complaint does not include any class allegations.
Shareholder Matter
Paul White, et al. v. H&R Block, et al.,Yuchong Smith, et al. v. H&R Block, Inc., et al., Richard J. Rodney, et al. v. H&R Block, Inc., et al., and Michael F. McCormack, et al. v. H&R Block, Inc., et al.,consolidated Case Numbers 02CV8965, 02CV9661, 02CV9682 and 02CV9830, respectively, in the United States District Court for the Southern District of New York, are matters filed in the third quarter of fiscal year 2003involves four cases in which the respective named plaintiffs seek to represent a class of shareholders who purchased the Company’s stock between November 8, 1997 and November 1,6, 2002, and allege that the defendantsCompany and certain of its current and former officers and directors violated Section 10(b)(5) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder by failing to disclose to shareholders various cases in which the Company had been sued regarding the RAL program, by failing to set adequate reserves for those cases, and by failing to disclose the supposed implications of those cases for the future of the RAL program. The four securities law cases havewere all been assigned to the same judge and consolidated for pre-trial matters. On January 13, 2003, the judge signed an order relieving the defendants from an obligation to respond to any of the four complaints until after aA consolidated complaint is filed. The consolidated complaint is to bewas filed in March 2003 withand the defendants’ response duedefendants responded by filing a motion to dismiss in April 2003. In response to defendants’ motion to dismiss, plaintiffs informed defendants that they desired further to amend their complaint. Defendants consented to the filing of an amended complaint as a pleading matter, the plaintiffs filed the amended complaint, and the defendants filed a motion to dismiss it in August 2003. The Company believes the claims in these actions are without merit and intends to defend them vigorously.
Shareholder Demand.A shareholderPeace of Mind Litigation
Lorie J. Marshall, et al. v. H&R Block Tax Services, Inc., et al., Civil Action 2002L000004, in the Company madeCircuit Court of Madison County, Illinois, is a demand in Novemberclass action case filed on January 18, 2002, through counsel thatas to which the Company commence a civil action against the directorscourt granted plaintiffs’ first amended motion for class certification on August 27, 2003. Plaintiffs’ claims consist of the Companyfive counts relating to the refund anticipation loandefendants’ Peace of Mind program under which the applicable tax return preparation subsidiary assumes liability for the cost of additional tax assessments attributable to tax return preparation error. The plaintiffs allege that defendants’ sale of its Peace of Mind guarantee constitutes statutory fraud by selling insurance without a license, an unfair trade practice, by omission and by “cramming’ (i.e., charging customers for the mattersguarantee even though they did not request it and/or did not want it), and constitutes a breach of fiduciary duty. A hearing on the motion to certify both a nationwide plaintiff class and a nationwide defendant class was held on August 14, 2003, and, on August 27, 2003, the court certified the following plaintiff classes: (1) all persons who were charged a separate fee for Peace of Mind by “H&R Block” or a defendant H&R Block class member from January 1, 1997 to final judgment; (2) all persons who reside in certain class states and who were charged a separate fee for Peace of Mind by “H&R Block,” or a defendant H&R Block class member, and that was not licensed to sell insurance, from January 1, 1997 to final judgment; and (3) all persons who had an unsolicited charge for Peace of Mind posted to their bills by “H&R Block” or a defendant H&R Block class member from January 1, 1997, to final judgment. Among those excluded from the plaintiff classes are involvedall persons who received the Peace of Mind guarantee through an H&R Block Premium office and all persons who reside in theWhiteTexas and similar cases noted above.Alabama. The shareholder’s demand indicated thatcourt also certified a shareholder derivative action will be commenced ifdefendant class consisting of any entity with the demanded civil action is not commenced. The shareholder’s counsel has, since receipt of the letter, agreed to relieve the Company and its Board of Directors from any obligation to respond to the demand at this time.names
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“H&R Block” or “HRB” in its name, or otherwise affiliated or associated with H&R Block Tax Services, Inc., and which sold or sells the Peace of Mind product. Defendants have filed a motion asking the trial court to certify the class certification issues for interlocutory appeal.
In additionThere are two other putative class actions pending against the Company in Texas and Alabama that involve the Peace of Mind guarantee. The Texas case involves the same attorneys for the plaintiffs as are involved in theMarshall litigation in Illinois and substantially similar allegations. The Alabama case involves allegations of selling insurance without of license in connection with the Peace of Mind program, the erroneous preparation of income tax returns that subjected plaintiffs to audits, failure to provide assistance in responding to auditors’ requests, failure to pay the penalties, interest, and additional taxes under Block’s standard guarantee and Peace of Mind programs, unjust enrichment, and breach of contract. No classes have been certified in either of these two cases. The Company believes the claims in these Peace of Mind actions are without merit and intends to defend them vigorously. However, there can be no assurances as to the foregoing matters,outcome of these pending actions individually or in the aggregate, and there can be no assurances on the impact of these actions on the Company’s financial condition.
Franchise Litigation
The Company is a named defendant in litigation entitledWilliam R. Smith, Inc., et al. v. H&R Block, Inc., et al., Case No. 99-CV-206379, pending in the Circuit Court of Jackson County, Missouri (previously known asArmstrong Business Services, Inc., et al. v. H&R Block, Inc., et al., Case Number 99-CV-206379, filed April 13, 1999, in the Circuit Court of Jackson County, Missouri, is an). The action was filed by 24certain “major” franchisees against the Company and certain of its subsidiaries relating to alleged breaches of contract and other matters. The Company’s subsidiary, HRB Royalty, Inc. (HRB Royalty), the franchisor under the applicable franchise agreements, filed a counterclaim and subsequently a motion for summary judgment seeking a declaration that HRB Royalty, Inc. could elect not to renew the major franchise agreements when their present five-year terms came to an end. Such motion for summary judgment was granted in March 2001 and the plaintiffs appealed. The Missouri Court of Appeals ruled in favor of HRB Royaltyupheld on December 24, 2002, holding that the provision in the franchise agreements for automatic renewal will not be held to require the renewal for additional five-year periods “except upon the mutual assent of the parties.” The plaintiff major franchisees’ motions to the Missouri Court of Appeals for a rehearing and for transfer to the Missouri Supreme Court were denied in January 2003. In February 2003, the plaintiffs applied to the Missouri Supreme Court for transfer of the case to that court and such application was recently denied. In 2000,appeal. HRB Royalty notified the plaintiff major franchisees in 2000 that it woulddid not be renewingintend to renew their respective franchise agreements asat the expiration of the nextcurrent renewal dateterms and that the agreements would terminate at that time. The renewal dates vary among the major franchisees. Pursuant to the terms of the applicable franchise agreements, HRB Royalty must pay a “fair and equitable price” to the franchisee or thefor franchisee’s franchise business, and such price shallmust be no less than eighty percent80% of the franchisee’s revenues for the most recent 12 months ended April 30, plus the value of equipment and supplies, and certain off-season expenses. While the Company expectsThe Circuit Court ruled in May 2003 that major franchise agreements with renewal terms scheduled to acquireexpire prior to July 1, 2003, will expire on July 1, 2003, and other major franchise agreements will expire as their renewal terms expire commencing in September 2003 and ending in fiscal year 2005. The Court ordered defendants to pay for the franchise businesses as provided in the next severalfranchise agreements on the applicable dates of expiration. During the six months ended October 31, 2003, franchise agreements of twelve major franchisees expired and subsidiaries of the Company began operating tax preparation businesses as company-owned operations in the franchise territories previously operated by ten former major franchisees. Cash payments of $118.8 million were made or accrued related to these former major franchise businesses during the six months ended October 31, 2003. In August 2003, a subsidiary of the Company entered into a transaction with one of the major franchisees whose franchise agreements had expired in the first quarter, pursuant to which such
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subsidiary acquired the stock of the franchisee and the franchisee released the Company and its affiliates from any further liability regarding additional payments under the major franchise agreements. In addition, during the first quarter of fiscal years, thereyear 2004, a Company subsidiary and one major franchise entered into a new franchise agreement with a limited term and a release of the Company and its affiliates from any liability in the litigation, including any liability regarding payments for the franchise business under the prior major franchise agreement. With the exception of the franchisees that have executed releases and the franchisee that entered into a new franchise agreement, the court will determine if any additional payments are required for these franchise businesses. There is no certainty ofas to the timing orand final cost of acquisition as to anycommencement of operations in the former major franchise business.territories or the payments of fair and equitable prices for the franchise businesses.
InArmstrongSmith, plaintiffs’ claims against the Company and its subsidiaries remain in the trial court. In their second amended petition, the plaintiffs seek in excess of $20 million in actual damages, punitive damages, unspecified statutory damages, declaratory, injunctive and other relief, including attorneys’ fees under allegations of breach of contract, breach of the covenant of good faith and fair dealing, unfair business practices, state anti-trust violations, breach of fiduciary duty, prima facie tort, violations of various state franchise statutes, fraud and misrepresentation, waiver and estoppel, ambiguity and reformation, relief with respect to a post-termination covenant not to compete in the franchise agreements, and a request for a fair and equitable payment upon nonrenewal of the franchise agreements. The major franchisees allege, among other things, that the sale of TaxCut®TaxCut income tax return preparation software and online tax services and the purchase of accounting firms encroached on their exclusive franchise territories. The defendants believe that the allegations against them are without merit and continue to defend the case vigorously. Management believes that amounts, if any, required to be paid by the Company and its subsidiaries in the discharge of liabilities or settlements relating to plaintiffs’these claims of the plaintiffs in this litigation will not have a material adverse effect on the Company’s consolidated results of operations, cash flows or financial position.
The trial involving one of the plaintiffs in theSmithlitigation took place in October 2003 and involved the issues relating to that plaintiff’s claims against the Company and to determine if any additional payments are required to provide the former franchisee with a fair and equitable price for the franchise business. The jury rendered a verdict of $0.9 million in favor of the plaintiff on the plaintiff’s claims against the Company and a verdict of $3.2 million with respect to additional payments for the franchise business. A subsidiary of the Company had made a payment of $5.0 million to such plaintiff as payment for the franchise business in the first quarter of fiscal year 2004. The outcome of the trial is subject to post-trial motions and possible appeals. The next trial to take place as part of theSmithlitigation is scheduled for May 2004.
Other Claims and Litigation
The Company and its subsidiaries have from time to time been party to claims and lawsuits not discussed herein arising out of its business operations, including additional claims and lawsuits concerning itsRALs and the Peace of Mind guarantee program, and claims and lawsuits concerning the preparation of customers’ income tax returns, the electronic filing of customers’ tax returns, the fees charged customers for various products and services, the Peace of Mind warranty program associatedlosses incurred by customers with income tax return preparation services, relationships with franchisees, and contract disputes.
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respect to their investment accounts, relationships with franchisees, denials of mortgage loans, contested mortgage foreclosures, other aspects of the mortgage business, intellectual property disputes, and contract disputes. Such lawsuits include actions by individual plaintiffs, as well as cases in which plaintiffs seek to represent a class of similarly situated customers. The amounts claimed in these claims and lawsuits are substantial in some instances and the ultimate liability with respect to such litigation and claims is difficult to predict. The Company’s management considers these cases to be ordinary, routine litigation incidental to its business, believes theand Company and its subsidiaries have meritorious defenses to each of them, and is defending, or intends to defend, them vigorously. While management cannot provide assurance that the Company and its subsidiaries will ultimately prevail in each instance, management believes that amounts, if any, required to be paid by the Company and its subsidiaries in the discharge of liabilities or settlements in these other matters will not have a material adverse effect on the Company’s consolidated results of operations or financial position.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
The annual meeting of shareholders of the registrant was held on September 10, 2003. At such meeting, three Class II directors were elected to serve three-year terms. In addition, the proposals set forth below were submitted to a vote of shareholders. With respect to the election of directors and the adoption of each proposal, the number of votes cast for, against or withheld, the number of abstentions, and the number of no votes (if applicable) were as follows:
| Election of Class II Directors | ||||||||
| Nominee | Votes FOR | Votes WITHHELD | ||||||
| G. Kenneth Baum | 154,492,796 | 1,939,685 | ||||||
| Henry F. Frigon | 150,062,319 | 6,370,162 | ||||||
| Roger W. Hale | 152,902,523 | 3,529,958 | ||||||
| Approvals of an Amendment to the 2003 Long-Term Executive Compensation Plan | ||||
| Votes For: | 142,940,871 | |||
| Votes Against: | 12,792,495 | |||
| Abstain: | 699,113 | |||
| Ratification of the Appointment of KPMG LLP as the Registrant's Independent Accountants for the year ended April 30, 2004 | ||||
| Votes For: | 151,578,294 | |||
| Votes Against: | 4,509,546 | |||
| Abstain: | 344,641 | |||
At the close of business on July 8, 2003, the record date for the annual meeting of shareholders, there were 180,313,591 shares of Common Stock of the registrant outstanding and entitled to vote at the meeting. There were 156,432,481 shares represented at the annual meeting of shareholders held on September 10, 2003.
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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
a) Exhibits
| 10.1 | |||
| Frank J. Cotroneo. | |||
| 10.2 | |||
| 2003 Long-Term Executive Compensation Plan (as amended September 10, 2003) | |||
| Certification by Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | |||
| 31.2 | Certification by Principal Accounting Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | ||
| 32.1 | Certification by Chief Executive Officer furnished pursuant to 18 U.S.C. 1350, as adopted by Section 906 of the Sarbanes-Oxley Act of 2002. | ||
| 32.2 | Certification by |
| b) Reports on Form 8-K |
The registrant filed a current report on Form 8-K dated November 1, 2002,August 27, 2003, reporting under Item 5 thereof its issuance that day of a press release containing the registrant’s response to market rumors regarding litigation involving refund anticipation loans (RALs).
The registrant filed a current report on Form 8-K dated November 6, 2002, reporting under Item 5 thereof its issuance of press releases on November 6, 2002 and November 11, 2002, relating to theHaese, et al. v. H&R Block, Inc., et al.RAL class action litigation pending in Texas, and describing under such Item theHaesecase and other pending RAL litigation.
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The registrant filed a current report on Form 8-K dated November 14, 2002, reporting under Item 5 thereof developments that day with respect to motions filed in theHaeseRAL litigation pending in Texas.
The registrant filed a current report on Form 8-K dated November 15, 2002, reporting under Item 5 thereof developments that day with respect to a fairness hearing held with respect to a pending settlement in theZawikowski, et al. v. H&R Block, Inc. et al.RAL class action litigation pending in Chicago, Illinois.
The registrant filed a current report on Form 8-K dated November 18, 2002, reporting under Item 512 thereof its issuance of a press release announcing the settlementresults of theHaeseRAL class action litigation in Texas.operations for its first quarter ending July 31, 2003.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| H&R BLOCK, INC. | |||||||
| (Registrant) | |||||||
| DATE | 12/10/03 | BY | /s/ | ||||
and Chief | |||||||
| DATE | 12/10/03 | BY | /s/ Melanie K. | ||||
| Melanie K. Vice President and Corporate Controller |
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FINANCIAL STATEMENT CERTIFICATIONExhibit Index
I, Frank J. Cotroneo, Chief Financial Officer, certify that:
| 10.1 | Separation Agreement dated September 4, 2003 between HRB Management, Inc. and Frank J. | |||||
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FINANCIAL STATEMENT CERTIFICATION
I, Mark A. Ernst, Chief Executive Officer, certify that:
| Cotroneo. | |||
| 10.2 | ||||||
2003 Long-Term Executive Compensation Plan (as amended September 10, 2003) | ||||||
| 31.1 | Certification by Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | |||||
| 31.2 | Certification by Principal Accounting Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | |||||
| 32.1 | Certification by Chief Executive Officer furnished pursuant to 18 U.S.C. 1350, as adopted by Section 906 of the Sarbanes-Oxley Act of 2002. | |||||
| 32.2 | Certification by Principal Accounting Officer furnished pursuant to 18 U.S.C. 1350, as adopted by Section 906 of the Sarbanes-Oxley Act of 2002. |
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